The current market dynamics are dominated by instability and with the recent announcements from the European Central Bank on rising interest rates, it’s time to look at the financial health of your startup.
Nowadays, there’s a lot of advice on ‘runways’ and how to cut costs to extend them. However, working with multiple startups and scale-ups we understand that drastically cutting costs isn’t per se always necessary.
This is the first part of a three-article series in which we will dive deeper into runways by looking how to forecast and optimise yours.
Let’s start with the basics: what is a runway and how do you calculate it by creating a financial forecast?
What is a runway
You can view your runway as your oxygen tank when you go scuba diving: it’s important to know how much oxygen you have before you start diving and at what point you need to come back to the surface.
The same goes for companies – you want to know how much cash you have to run your operations and invest, as well as when you need to prepare for acquiring new capital.
“Companies go out of business not because of bad ideas but because of a lack of cash” – Scott Galloway
Eventually, you want to dive for as long as you can, so let’s take a look at how to calculate your runway to know how much oxygen you have.
How do you calculate your runway?
Your starting point is the current balance on your bank account.
The quickest and easiest way to determine your runway is to divide the current amount on your bank account by your average net burn. For example, if your current balance is € 750.00 and your average net burn rate is € 77.500 your runway will last for 9,6 months which we round down to 9 months.
However, this example will give you only a rough estimation of your runway. Personally, I don’t find this method good enough, because looking only at historic spending can determine an incorrect estimation of your runway.
This formula is an oversimplification of reality and in my opinion, it’s best practice and worth the effort to look critically into your future spending because it leads to a more accurate runway.
However, there are several risks involved when choosing this method to calculate your runway, such as:
❏ It doesn’t account for upcoming yearly expenditures like yearly paid subscriptions.
❏ It doesn’t account for future investments.
❏ That new employee who will start working next month.
To return to the scuba diving example: you want to be sure of the exact moment when you need to go back for new oxygen and not estimate that moment solely based on the average time an oxygen tank lasts.
So, here are 5 steps to make sure you know the exact time left of your runway.
Step 1: How much oxygen do you really have?
1.Make sure that your books are up to date.
2.Know the current balance on your bank account.
3.Take a good look at your outstanding sales invoices (accounts receivable) and note the amount of the open sales invoices. Make sure that you take immediate action for the invoices that are past due!
4.Take a good look at the outstanding purchase invoices and taxes if something is overdue make sure to pay it or get a payment arrangement to prevent further costs.
5.Finally, determine the difference between the money that you have to collect and the money that you have to pay. Add or detract this from the current balance on your bank account.
The steps above make sure that you exactly know how much oxygen you are going to dive with.
It “cleanses” your balance and gives you, money-wise, a clear starting point.
Step 2: Design your oxygen meter (i.e the financial forecast)
Now that we know how much oxygen there is in the tank, it’s time to design your oxygen meter. With it, you can measure how much oxygen you are using and how much is left. During the dive, you want to keep track of your oxygen levels so that you know whether you can stay underwater a bit longer or you need to resurface sooner.
In my opinion, the best practice to design this oxygen meter is to create a financial model that represents the structure of your profit and loss account.
There are three general principles that you should follow when designing this financial model:
❍ Costs and expenditures are not the same!
❍ Use input variables in your model to represent the correlations that you have in your business model. (e.g. costs that are related to your revenue. For every euro of revenue you have to pay 10% to the sales partners.)
❍ Be realistic and honest with yourself when you are making assumptions.
❍ It’s a good idea to build in “sandbags” (i.e. safety measures) since most humans have an optimism bias. For example, say your costs of goods sold are 10% of your revenue, then take into account 11% or 12% just to be safe.
Step 3: Where do you get fresh oxygen?
We know how much oxygen there is in the tank and we have designed our oxygen meter now it’s time to make the meter work.
Think about your cash-in as your underwater oxygen supply. The same goes for your runway where the money that you are collecting from customers is your oxygen supply underwater.
We can predict the oxygen supply by adding the following data to the financial model from step 2.
1. Use historic data as input such as:
✓ Inbound versus outbound revenue
✓ Your days sales outstanding (DSO) which is measured by the average number of days that it takes to collect the money after a sale.
✓ Seasonal trends
2. Calculate how much revenue you are expecting to make
3. Extrapolate this information to the future. Don’t forget to be realistic and to use “sandbags”.
4. Put the collection of the expected revenue in the correct month and use your DSO as input.
Step 4: How much oxygen are you using?
By now we know how full the oxygen tank is, we have designed our oxygen meter and know how much supply of oxygen there is underwater. The next step is to calculate how much oxygen you are using.
The most important thing to remember with cash-out is: there is a difference between costs and expenses. For example, the annual paid subscription costs are divided over 12 months but the expense takes place in one month (i.e cash-out).
Other things to keep in mind while looking at your cash-out are:
❏ Employers contribution to social security;
❏ Investments into equipment or software
❏ In some cases holiday pay (again the difference between costs and expenses).
List all these costs and plot them in your model. The best way to do this is to calculate these costs by using input variables. This way, you can create several scenarios with your costs and see the direct impact on your runway. This brings us to our final step…
Step 5: Bring it all together in the financial forecast
Now that you have all the information on your oxygen tank, the oxygen supply and how much you are going to use, it’s time to calculate the amount of money left at the end of the month (i.e the cash balance of the said month). Eventually, you use the ending cash balance of the previous month as the starting cash balance of the new month. Typically, you want to model this financial forecast for the upcoming 12-18 months.
This forecast provides you with a timeline that, eventually, will allow you to take proactive measures instead of reacting measures, thus extending your runway.
However, one thing is clear: your runway ends in the month that your cash balance is going to be less than zero.
In the next post, we are going to explore how you can improve your underwater oxygen supply. In the meantime, feel free to reach out to us for further questions on determining your runway.