When running a business, you must consider how cash affects your business. The inflow and outflow of cash will determine your profits and losses. While most businesses were created to make profits, business activities may also result in losses. When these losses occur, it’s important to learn how to manage them properly for the continuity of the entity.
The cash runway is a concept that describes a business’s capacity to operate despite running at a loss. But what exactly does it mean and how does it affect your business? Keep reading to find out more.
What is a Cash Runway?
A cash runway is a duration a business will continue to function before its cash balance reaches zero. The reduced cash balance would result due to recurring losses. Any company that’s currently running through venture capital will require this metric. Investors will check this metric to determine how the losses and the cash balance of the business is operated. In reality, there are different types of cash runways – team cash, company cash, and founder cash.
There’s a close connection between the cash runway and burn rate of a business. To calculate your cash runway, you’ll divide total cash by the average net burn rate. Another method to calculate cash runway is dividing your cash reserves by your monthly net burn.
What is the Importance of a Cash Runway?
The following represents the importance of cash runway;
- It indicates the duration you need before securing your next round of investments. You’ll learn exactly how much you need to achieve your next milestone and request for additional funding. Cash is vital to the existence of your business. As a result, the metric will explain how much longer you can stay in business with your current funding.
- It’s an indicator of underlying business inefficiencies. Tracking your cash runway will let you understand if anything is wrong with your business. You’ll also understand when these inefficiencies start to hurt your business. If your net burn rate has spiked for the past few months, you may need to look closely at your business’s expenses.
- It breeds investor confidence. Most investors want to know how their money will be utilized in your business. Cash runway is relatively easy to understand. In one glance, it will give investors a clear view of where your business currently stands. A large cash runway means your business has more time to sort issues and settle any obligations.
- It will show you if you have more room for larger investments. A large cash runway isn’t necessarily the best thing for a business. You’ll need to spend this money to support your growth when seeking funding as a small entity. A massive cash runway may mean your business has failed to utilize its resources, which may stunt its growth. A cash runway will help you avoid negative cash flow, but you must strike a balance.
What are the Challenges For Calculating Cash Runway?
To calculate a cash runway, you may need to note the following challenges;
- Evolution of business activities. The truth is that business operations change frequently. Therefore, the items you spent in the previous year may differ from your current needs.
- The cash runway is calculated based on historical data. By calculating your cash runway with this method, the business owner may fail to account for future growth. These static metrics can be misleading, and misinterpreting a cash runway can be detrimental.
- Cash expenses may sometimes differ from what’s recorded in financial statements. For instance, a business may record a marketing expense of $5,000. But they may only spend $2,000 during the first eight months of the year.
And that’s all on the importance of a cash runway. Clearly, a cash runway is essential to the business’s success. You can apply the major points discussed in this piece to your business. You’ll enjoy notable improvements.