Hardware Startups: You Need to Understand Cash Flow

I’ve spent a lot of time recently helping companies with their financial projections. This is the first of two posts I’m going to write addressing some common mistakes that I see in forecast. This post is focused on an overarching point: your forecast should be cash flow forecast. This is important for everyone, but especially critical if you’re building hardware. My next post will be more about some tactical tips for building a robust, user-friendly model.

Why Cash Flow?

It’s really simple. You need to know when you’re going to run out of cash. Investors want to know when you’re going to run out of cash.

The Problem

The problem is a lot of companies produce forecasts that look like an income statement where revenue and the cost of goods sold are nicely matched. Unfortunately, real life doesn’t look like an income statement. In reality:

• You have to order raw materials before you can manufacture your product. Cash is going to go out the door to purchase those materials long before you receive anything from customers.
• You’ll likely want to hold some finished goods in inventory. That means you’ve spent cash to produce them, but aren’t actually selling them and getting any income from customers yet.
• Your customers will almost certainly push for some sort of credit terms where they don’t have to pay you in full for 30, 60 or even 90 days after receiving the product.

Thus — there is a gap between cash going out the door to create the product and cash flowing in from customers. An income statement forecast might show explosive growth when in reality the company will run out of cash long before it ever gets there. Depending on the payment terms you negotiate with your suppliers and customers, and how much time your goods spend in inventory, this gap can be significant.

To make matters worse, the gap between cash flowing out to suppliers and cash flowing in from customers is generally larger for startups.

• Your suppliers aren’t confident that you’re going to be around to pay them 30 or 60 days from now and may very well require up-front payment.
• Your customers are often more important to you than you are to them, or at least have more leverage/experience in negotiations, and will push for longer repayment terms for themselves.

So, reality probably looks something like this:

Fast Growth = Less Cash

In general, the faster you grow, the more cash flow issues rear their ugly head. The higher your gross margin, the more flexibility you’ll have since you’ll have more cash to recycle and invest in growth, but it’s always a factor. Think about it: you’re spending cash today for the goods you’re going to sell later. The more goods you’re selling later, the more cash you need to spend now to produce them. The faster you grow, the more cash you’re going to need to put up to do it.

How to improve:

Build a cash flow forecast that looks forward for 12–18 months.

• Start with cash balance
• Add sources of cash — investment and payments from customers
• Subtract uses of cash — material purchases, salaries, rent, and all other expenses
• End with ending cash balance. This becomes the next month’s starting cash balance.

The tricky part is making sure this accurately represents your cash flow dynamics. Make sure you understand and correctly model:

• Payment terms with your suppliers (i.e. when do you owe them money?). When negotiating with suppliers, try to get the longest repayment period as you can.
• Payment terms with your customers (i.e. when are you getting cash in from customers?). When negotiating with customers, try to get paid as quickly as possible.
• Time spent in inventory — how long are items sitting in inventory? Try to minimize the gap between purchasing materials and actually getting a finished product in the hands of customers.

It can be helpful to examine financial statements of public companies in your industry to make sure you’re capturing all of the major expense categories and may help inform typical cash flow timing in your industry.

In the early stages with a limited number of customers and suppliers, you can probably do this in an Excel spreadsheet. As the business grows and things get more complicated, you’ll probably need to use a more sophisticated software package, but that’s beyond the scope of this post.

A few final thoughts

Cash flow assumptions will likely change over time. As I mentioned earlier, when there’s fast growth cash needs become substantial. Luckily, that’s also a time at which suppliers may agree to better terms because they see your business looks more secure and promising. It’s important to build a robust model that lets you update assumptions easily (stay tuned for my upcoming post for more info).

Hardware companies can ease cash flow shortfalls with bank and asset based loans as they grow. There are lots of different options including accounts receivable financing, factoring (selling receivables), inventory financing, and purchase order financing. I won’t spend a ton of time here — this could warrant a post all to itself — but just note that there are options.

Note: I recently published an eBook on financial modeling called The Founder’s Guide to Financial Modeling. It provides a step-by-step guide to building a financial model and includes a sample Excel model to illustrate concepts.