Cash is important for survival. The burn rate (how fast you ‘burn’ the cash in your business) is the constant focus of both investors and early stage entrepreneurs. However, there are other ways and reasons that determine the importance of cash.
Cash can’t be tweaked
First, cash is the king because it cannot be changed. You cannot lie about cash. There are some numbers on the balance sheet or the business plan that can be manipulated to reflect opinions. Cash is not an opinion: the amount of cash you have is written in the summary of your bank account. Each company, especially new ventures, have to have a continuous focus on cash for two reasons. First, it is a measure of true profitability and second it allows and supports the continuation of the company.
But then why the focus on cash and not on profit? The distinction derives from the so called financial and accounting cycle of a company. These two cycles, that determine the final amount of cash and the profit respectively, can not be synchronized. The first reason is that the day in which you account for a sale is the day in which you sign the contract, while the day in which your bank account registers the sale is when the cash is received. This usually happens a month or so later. In that month, the company has to confront a lot of financial obligation or expenses. These could be salaries or debt payments and it cannot pay them without cash.
Cash is a way of surviving
Investments are also important in distinguishing between the two cycles. An established company usually can borrow or issue equity to finance almost everything it thinks about. For a startup, new investments are likely debt payments: you have to make them or you are out of business. But raising money is a draining and expensive process in terms of time, energy and also money. In this environment, cash becomes extremely important.
The burn rate is the main focus of investors
The calculation of cash needs, expenses, the difference with profits and the burn rate are also important in dealing with investors. Indeed, investors usually hope to get their money back and the only two ways to do this are selling the participation to either externals or to the company itself. In both cases cash is critical. In the first case, the first question the new buyer will ask is: is the company self sustainable and generating cash? And the more cash the company is generating, the higher the price for the participation will be. Regarding the sale of the participation back to the startup, the company needs to have enough cash to pay for the acquisition or to pay dividends.
It determines the value of your company
All these reasons combine in determining that cash is the driver of a company’s value and thus of the valuation procedure. Among the different valuation methods, the discounted cash flow is the most widespread. This method discounts cash flows generated by the company in given periods and tries to understand its value. Obviously, the larger these values are, the larger the value of the company will be.
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Cash metrics should be taken in high consideration by the entrepreneur and should be watched closely. Cash and the burn rate are the metrics of the healthiness of the firm and determine its survival.