No backers and no way back? Don’t panic about cash flow

Are worries about cash flow keeping you awake at night? Reaching the end of the financial year (EOFY) in one piece can feel like an uphill battle for many working in the innovation space. And a capital crunch that blows a hole in your cash flow position is often the culprit. A cash crisis for a start-up, scale-up or established business can take different forms. Some are one-off, heart-stopping dramas — for example, your investor backs out at the eleventh hour — while other cash-flow problems can fly under the radar until you finally notice them. Depending on your circumstances, closing out your books at the end of a financial year can either highlight or add to your company’s cash flow problems. So we’re examining the common cash-flow crises that can leave your business fighting to survive another year and what you can do to turn your cash-flow position around.

Why do businesses experience poor cash flow?

Keeping your cash flow pulsing is a priority, and it can be challenging for any business. But it’s even harder for start-ups, scale-ups and established businesses with R&D, because R&D is expensive, which means capital often flows out faster than it flows in. Start-ups, especially early-stage ones, might not have any revenue, and those that do probably don’t make enough sales to cover their expenses. By contrast, revenue may be flooding in for scale-ups, but the eye-watering amounts of capital needed to feed exponential growth can easily outstrip sales income. Even established businesses with R&D programs are not immune. Sure, they’re more likely to have healthy revenues and stable financials, but they’re also more likely to have cash flow targets. And if they have a cash shortfall, they’ll probably pause their R&D programs to shore up their core operations.

Cash-flow shortfall scenarios

Innovation businesses need funding to push their R&D forward, and investor capital, loans and grants are the go-to solutions for cash-flow headaches. But these options aren’t trouble-free. An investor you were counting on can suddenly get cold feet. Your bank can refuse to lend your company money. That government grant — the one you were sure you could land — can fall through. These are the cash flow crises that can push your business to the brink.

But they’re not the only type of cash-flow catastrophe your venture can face. Some cash-flow calamities can sneak up and surprise you when your business seems to be running along nicely. Late-paying or non-paying customers, and sky-high product returns or service cancellations can tank your company’s cash flow without your noticing at first. These seemingly covert cash-flow pitfalls can derail your plans to secure investor backing or debt financing. So, let’s lift the lid on what these backers are looking for before they fund your venture.

Cash-flow red flags for backers

Picture this: your business is going well, the company is growing and your accounts look good. Then, out of the blue, the loan you applied for gets declined, and the investor you had on the hook has started screening your calls. So, what went wrong? Angel investors, venture capitalists and lenders know their way around a balance sheet, a profit-and-loss account and a cash-flow statement. If you want to attract backing, you need to know what moves the needle in favour or against a successful funding decision for your business. Here are the red flags that send backers heading for the hills.

1. High stock-based compensation ratios

Companies use stock-based compensation to reward their employees by giving them shares in the business instead of cash. It’s a handy tool for start-ups and scale-ups because it’s a non-cash way to attract and reward employees. But if you overuse stock-based compensation, you can overdilute your company’s equity and scare off would-be investors. Here’s the formula you need to work out your stock-based compensation ratio:

Total stock-based compensation ratio = total stock-based compensation/total revenue

Key takeaway: This should be under 30% if your business is a high-growth scale-up, growing more than 30% per year and under 10% if your venture is growing slowly (less than 10% a year).  ^[1]

2. Negative operating cash flows

Operating cash flow (OCF) is the sum that reveals your typical cash position with laser-like precision. So when they’re doing their due diligence, investors and lenders will be all over this number like a rash. Here’s the formula you need to calculate your OCF:

OCF = operating income + depreciation – taxes + change in working capital

Key takeaway: Your OCF tells you if your venture company has enough money to cover its bills, taxes and operating expenses. Companies that are financially viable in the long run have positive OCFs. That’s why lenders and investors tend to steer clear of companies that don’t.  ^[2]

3. Low operating cash-flow to net income ratio

The ratio between your company’s operating cash flow and net income gives investors valuable insights into the quality of your venture’s earnings.  ^[3]

Cash flow to net income ratio = operating cash flow/net income (total revenue – total expenses)

Key takeaway: If operating cash flow is lower than the net income, it flags low-quality earnings, such as revenue tied up in accounts receivables (unpaid invoices or past due invoices) or understated expenses. For all those reasons, it’s something investors won’t want to see in your business because it suggests cash-flow problems are on the horizon.  ^[4] And for that reason, it’s a good idea to calculate this metric for your innovation business and take action if it’s on the low side.

4. Large differences between net income and free cash flow

Your net income (total revenue – total expenses) and free cash flow (FCF) should roughly match. FCF tells you about your venture’s disposable cash, so it’s a handy calculation for budgeting and planning. Here’s how you work it out:

FCF = net income + depreciation/amortisation – change in working capital – capital expenditure

Key takeaway: Investors will be on high alert for any significant differences between net income and FCF, especially if that’s happening over time. To address investor concerns, be ready to explain why your FCF and net income are diverging. ^[5]

Having one of these cash flow issues in your business, whether it’s hiding in plain sight or not, doesn’t automatically dash your hopes of getting a backer. But it’s crucial you know why your cash flow is on shaky ground and how you can fix it. Let’s look at what you can do if you have a hole in your cash flow.

How to plug a cash-flow gap

Cash-flow issues (big and small) happen when the cash your business has from income and the cash your business spends on costs are out of kilter. When that happens, a gap appears in your company’s finances and, depending on your circumstances, you may need to fill that gap quickly. Cash-flow problems can happen at any point, but they’re common at EOFY. Even if your company’s income year doesn’t follow the financial year and has a calendar-year income period, tax time can generate curve balls. For example, you may need extra capital to complete a customer order or an R&D activity by 30 June, which can add to existing cash-flow pressures. A government grant could fall through when you need to invest in stock or equipment capital for a project with a 1 July start date, highlighting that your business lacks sufficient cash flow to weather an unexpected setback.

With the clock ticking on the current financial year, if you have a cash-flow crisis, you may need to act fast. Here are a few things you can do.

• Cut costs

Look at your expenses and cut anything that’s not essential. For expenses, reach out to your suppliers and your landlord to negotiate a payment holiday or extend your payment terms on product or service purchases.

• Check your cash conversion cycle

The cash conversion cycle (CCC) is how long your business takes to convert resources into cash from sales. It has three components: the sales cycle, the delivery cycle, and the billing and payment cycle. If you can speed up all or even any one of the CCC elements, you’ll accelerate how quickly your company receives cash. For example, you could shorten your payment terms or speed up the production or delivery of your product or service to customers.

• Access bridge capital

Bridge capital or bridging finance is usually a type of short-term debt financing, and many lenders offer it. But if your business is claiming the R&D Tax Incentive (R&DTI) refund, a Radium Advance is an easy way to access bridging finance quickly and your tax refund early. There’s only one condition to apply for a Radium Advance: your business needs to be eligible for the R&DTI. It’s cash-flow friendly and there are no repayments until your loan matures. It’s a good bridging option when your business is in a pinch because approvals and funding for Radium Advances are quick.

Planning for a new financial year

Having said all that, Radium Advances are best when you use them regularly in your business rather than as a one-off burst of bridge funding. Indeed, once your cash-flow crisis passes (and it will), we recommend identifying funding sources that can give your business consistent capital. Regular Radium Advances throughout the year will give your venture the steady funding you need to meet your innovation and growth goals. They can strengthen your company’s capital stack and give you a reliable source of capital that complements your other debt and equity funding. Take a look at the resources section of our website to find out more. It’s packed with articles on how to build a diverse capital stack, crucial calculations for start-ups and scale-ups and how to manage your burn rate. The bottom line is companies with steady cash flow find it easier to attract new lenders and investors. So, make this your number one priority in the new financial year and see your business and R&D soar.

 

[1] Long Term Mindset (2024). Cash Flow Statement Red Flags (3 Warning Signs). [online] YouTube. Available at: https://www.youtube.com/watch?v=WOORGfJdlK8

[2] Investopedia (2024). Free Cash Flow vs. Operating Cash Flow: What’s the Difference? [online] Investopedia. Available at: https://www.investopedia.com/ask/answers/111314/whats-difference-between-free-cash-flow-and-operating-cash-flow.asp.

[3] Long Term Mindset (2024). Cash Flow Statement Red Flags (3 Warning Signs). [online] YouTube. Available at: https://www.youtube.com/watch?v=WOORGfJdlK8

[4] Jyoti Singh (2018). Quality of Earnings (Example) | Top Indictors of Earnings Quality. [online] Wallstreet Mojo. Available at: https://www.wallstreetmojo.com/quality-of-earnings/.

[5] Long Term Mindset (2024). Cash Flow Statement Red Flags (3 Warning Signs). [online] YouTube. Available at: https://www.youtube.com/watch?v=WOORGfJdlK8