Venture-backed, early-stage companies should use accrual accounting - I won’t get into the detail here as to why, but if your goal is to raise serious VC funding or get acquired by a public technology company (or eventually have an IPO), you need accrual-based accounting.
The impact of working capital on a startup’s burn rate is one of the items that can come as a surprise to first-time founders. After all, shouldn’t the income statement show a company’s cash burn?
Unfortunately, the answer is no.
Why? The biggest item that regularly makes a “traditional,” VC-funded startup’s operating loss not equal to their cash burn is working capital.
Working capital 101 for early-stage companies
As we’ve mentioned before, Working Capital = the difference between current assets and current liabilities on a company’s balance sheet. What this really means for most startups is the difference between when a startup gets paid by clients vs. how long it has to pay your expenses.
Founders need to understand a few key items to understand how their cash burn may differ from their income statement’s operating loss.
- Got a sale? Great, you’ve got probably got revenue on your income statement! BUT, did the client pay you yet? If not, you didn’t get “cash” for that revenue, you got “Accounts Receivable.” Otherwise known as “AR,” this lives on your balance sheet in the current liability section. When your client actually pays you, your AR goes down and your cash should go up! (Go collect on that revenue!) It’s pretty normal for a company selling to enterprises to have AR; big companies are smart with their cash, and usually wait until the last possible moment to pay you.
- Did you pay all your expenses? Or do you owe vendors something at the end of the month? If your vendors provided goods or services to you, but you haven’t yet paid them, then you likely have “Accounts Payable.” Different vendors have different payment terms, so you should use this to your advantage. But remember, in accrual accounting, if you use a service/get invoiced by a vendor, you’ll see it on your income statement even if you haven’t paid them yet - thus, making your operating loss different from your cash burn.
- Are your customers paying you ahead of time? This is pretty typical for a lot of SaaS businesses. Deferred Revenue is when a client pays you ahead of you delivering a service. For example, if you charge a client’s credit card for a 12-month subscription, contracts - you just got 12 months of cash from that client! But you owe them the subscription, so Deferred Revenue gets added to your balance sheet as a liability. The offset to this on your balance sheet is cash - so you’ll have more cash flow than your income statement would “predict.” Not a bad problem to have… Watch our deferred revenue video here.
- Bonus item: your corporate card. This is a nice way to stretch your payments/conserve cash. It’s typical for a startup company to have some outstanding balances due to their card; and if you haven’t paid off your card, you may have more cash in the bank than your income statement would predict. (We’ve got recommendations on great cards for early-stage companies here if you need one. In particular, if you are carrying a balance on your card, make sure you don’t have personal liability - you don’t want to have to pay that out of your own cash if your startup goes under!)
- Bonus item for hardware and eCommerce companies: If you are selling hardware or if you have inventory, your cash burn may be quite different from what your operating income would suggest. So you better buckle up and really understand how money is leaving your business - this can especially become a problem for fast-growth companies that have to add a lot of inventory ahead of actually selling that inventory. You can get into a real cash crunch - pay attention!
Paying attention to your cash, and the capital movements on your balance sheet will help you be a better founder. Good luck managing your cash burn and your working capital!