Published by MBA Skool Team, Published on July 17, 2016
Cash has been long known to be the lifeline of any business. Every business needs to meet their expenses- routine or ad-hoc, and to do that, cash is required. In order to ensure the availability of cash if and whenever it is required, the businesses must be able to forecast their expenses due in advance and plan their investments accordingly. Broadly, this is what is known as cash management. Old and established businesses develop effective cash management models over time. However, for startups, where other issues like urgent customers, limited resources, looming deadlines make up to the priority list, this aspect of financial management ends up being neglected and ignored. In the midst of these priorities, they forget the fact that poor cash management is credited to be one of the major reasons behind the failure of startups.
Why ‘Cash should be King’ to startups?
The phrase ‘Cash is King’ is adequately suited to startups for all the reasons which if ignored lead to the failure of a potentially successful startup. The reasons can be stated as under:
1. Small initial capital
Startups, unlike other well-established businesses, do not have large capital which can be put under risk expecting returns in the long run. Although the return seems to be large, the cost that the startup might incur due to the risk involved is higher. The capital is limited and is a constraint to the kind and the size of investments the startup can make in assets etc. Thus, it becomes very important for the startups to manage and look into the way that limited capital is put to use, hence preserving the capital.
2. Investor sentiment at stake
Startups have a small capital base relative to other companies which are old enough. This puts them under another important task of building and maintaining investor confidence in them. Any unrequited activity which largely affects the company’s valuation may end up affecting the investor sentiment in the market, hence shutting gates to future funding prospects for the firm.
Consider a scenario where the firm reaches a stage where it is unable to meet some very important expenses due to shortage of cash, the reason being there are a large number of account receivables. This shows that the cash cycle of the firm is problematic. In the long run, the firm may lose market share, move farther away from breakeven and the investors for sure would not like it.
3. Liquidity requirements
Every firm has an option of either keeping the entire cash in hand or resort to other options such as bank FDs. Keeping cash in hand does not earn any interest and hence the firms try to keep as much cash as possible in the other forms available in order to earn returns on the cash. However, it is important to note that the liquidity requirements for a startup are difficult to establish and hence it becomes critical to decide in which financial instrument the cash needs to be put in while earning as much interest as possible. This forms a part of the cash management process of the firm.
Not only this, the firm also needs to predict or forecast their liquidity requirements in advance so that the amount of cash to be put into these financial instruments can be decided.
4. Need to attract customers
Every firm which is in the introductory stage of their life cycle needs to do heavy sales promotion to encourage trial and attract early adopters. A huge amount of funds is required for this purpose while the returns are negative. Thus, a very critical task for the startups at this stage is to manage their cash as effectively as possible. The cash cycles need to be adequately maintained until the growth stage is achieved where the sales promotion activities are trimmed down to a bare minimum. Failing to do so might lead to the firm running out of cash.
For example, consider the case of Ola and Uber in India where they offered huge discounts on rides and free rides in the initial years. Ola even provided large incentives to the drivers. However, they have trimmed down those activities lately since that they are on the growth curve now.
5. Ad- hoc expenses
Unlike the well established firms, startups need to survive a very volatile environment. The competition is tough, waters are new, expenses are ad-hoc and if not tracked, they may have to incur a very large opportunity cost in terms of the market share etc. The ad-hoc expenses cannot be forecasted but the cash needs to be managed accordingly in order to meet all these expenses as and when required.
6. Hiring and retaining employees
This is another function that gets affected if the firm does not have enough cash in hand. The employees need to be compensated adequately and in time. The firm needs to match the industry standards in terms of the benefits they provide as well. This is very important to retain good employees and attract new talent.
How to do it?
Cash management is not rocket science but involves just a three broad steps which can be explained as under:
1. Cash collection and disbursement
This involves managing the cash conversion cycles of the firm. The cash conversion cycle is defined as the number of days it takes for the company to convert the input resources to cash. It involves the difference between the no. of days payable outstanding and the no. of days receivable. To ensure that the firm has enough cash, the no. of days receivable should be as less as possible i.e. the customers must pay as early as possible. Although it seems a bit unfair, but the no. of days payable outstanding i.e. the no of days it takes for a firm to pay for its expenses can be maximized as much as possible thus ensuring a faster and smaller cash conversion cycle. Specifically in the case of startups, the focus must be on this aspect of cash management since there is limited availability of cash.
2. Cash flow analysis
Proper analysis of the cash flow in the company can help the company identify all the unnecessary expenses that the company had been incurring in the past and the ways in which the cash holdings of the company can be managed. Cash flow analysis also helps the company reduce its cash conversion cycle.
3. Cash flow forecasting
The last step and the most important aspect of cash management is cash flow forecasting. As explained earlier, in order to manage its expenses, it is important for the firms to forecast their expenses beforehand and plan their investments accordingly. Cash flow forecasting forms a part of that. It allows the firms to be prepared to face uncertainties.
Although cash management seems not that important to startups, it is important to realize that effective cash management is the key to success. In an era of extreme volatility and uncertainty, the financial health of a startup matters as much as the other aspects such as market share and looming deadlines do. Hence, it is high time this is realized by entrepreneurs and the priority list revised with an inclusion in it.
This article has been authored by Kavisha Agarwal from IIM Raipur