Every business needs cash — not only to keep the lights on, but to make strategic investments for growth. Managing cash flow isn’t easy, and it can be particularly challenging at a rapidly growing SaaS startup.
Most SaaS businesses generate revenue from subscription-based solutions or annual contracts. The very nature of the SaaS business model can produce “lumpy” — even mercurial — cash flow reliant on when new business comes in, contracts are renewed, and customers churn out. Additionally, growth investments often take time to spur revenue.
A SaaS startup that grows too quickly risks burning all of its cash. From a lag in return on investment to the potential for customer churn, many factors can create a cash flow crisis and threaten a young startup’s success. Fortunately, a little fiscal knowledge can help ensure your cash stream doesn’t run dry.
This easy-to-follow guide to cash flow for SaaS startups covers all the basics, including:
Cash Flow Explained
Cash flow is dynamic — revenue from sales is often quickly used to cover bills, payroll, asset purchases and other expenses. Startups must assiduously track revenue and expenses while maintaining ample runway to meet growth goals. To plan for sustainable long-term growth, business leaders have to understand how much cash they have on hand (working capital), how much cash they’re generating and where it comes from (inflows), and where it’s being spent (outflows).
What it means to be cash flow negative
A business is cash flow negative when more money is going out than coming in. That means you can’t cover expenses with the revenue you’re generating from sales alone, and you have no excess cash on hand in a given time period. It’s common for a new business to have negative cash flow, as it takes time and careful management to generate cash inflows that exceed investments.
Negative cash flow isn’t necessarily bad. A business needs enough money to cover operating expenses. Even successful businesses won’t turn a profit every month, and growth investments typically eat into free cash until they produce enough additional revenue. However, if negative cash flow is overlooked or uncontrolled, it can cripple the business.
Why do SaaS startups have negative cash flow?
Many SaaS businesses, especially startups, have negative cash flow. Growing the business can require upfront investments in sales and marketing, product development, and talent acquisitions to attract and retain customers and increase sales revenue. SaaS payment structures also affect cash flow. Monthly payments generate smaller, consistent revenue for the business, whereas annual payments produce larger upfront sums to cover expenses throughout the fiscal year.
Though negative cash flow is normal for a growing SaaS startup, it’s important to keep a close eye on inflows and, most important, on outflows to ensure you can pay your team, your taxes, and other essential expenses. Ultimately, you want to avoid growing too quickly; make sure you have a path to becoming cash flow neutral (breaking even) or cash flow positive.
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What it means to be cash flow positive
A business is cash flow positive when more money is coming in than going out. Normal business operations generate enough cash to cover bills and expenses, with some to spare. It can be achieved by increasing sales, reducing expenses, or securing financing.
What’s the ideal time frame for a startup to become cash flow positive?
That depends on many factors, such as the industry you’re in, your funding trajectory, and your growth plans. For example, startups with significant capital expenditures, such as equipment and hardware costs, may be slower to generate positive cash flow than a SaaS startup with a more capital-efficient cost structure. If your startup is planning to scale rapidly, you’re likely to burn a bunch of cash to reach your growth goals. Once you’re there, you should be in a better position to maintain positive cash flow.
Growth at any cost is no longer the norm, so it’s never too soon to have a plan to become cash flow positive and prove you have a viable, sustainable business. When the time is right for your startup, there are many benefits to having positive cash flow.
The benefits of maintaining positive cash flow
Contrary to negative cash flow, positive cash flow indicates that money is flowing into the business faster than it’s going out. With consistent positive cash flow a business can:
Operate smoothly
Budget and plan for the future
Cover unexpected expenses
Invest in growth opportunities
Positive cash flow provides financial stability as well as the flexibility to invest in new projects (R&D) and expand the business into different markets and segments. You won’t have to raise capital in a pinch, either.
RELATED: How to Improve SaaS Cash Flow
Does positive cash flow mean the business is profitable?
Positive cash flow does not guarantee a business is profitable. For example, a business can be increasing revenue and improving cash flow, while not making a profit, because it has a substantial amount of debt. Conversely, a business might make a profit month after month and not have enough cash to make payroll because its money is illiquid, tied up in hard assets or accounts receivable.
Let’s dig into the difference between cash flow and profit so you have a clear understanding of these important financial metrics.
Cash Flow vs. Profit
People often confuse cash flow and profit. They are not the same. Understanding how they are different will ensure you make strategic decisions based on an accurate assessment of your business’s performance and financial health.
Definitions
Cash flow refers to the net balance of cash moving into and out of a business at a specific point in time. Cash flow is typically reported in the cash flow statement, a financial document designed to provide a detailed analysis of what happened to a business’s cash during a specified period. The document shows where a company used or received cash, and it reconciles the beginning and ending cash balances.
Profit is the balance that remains when all of a business’s operating expenses are subtracted from its total revenues. Information about a company’s profits is typically communicated in its income statement, also known as a profit and loss statement (P&L). This statement summarizes the cumulative impact of revenue, gains, expenses, and losses over the course of a specified time frame.
How are cash flow and profit different?
Put simply, cash flow is the cash a company receives and pays out; it shows whether liquid assets are increasing, decreasing or breaking even. Profit is the total revenue after disbursing all business expenses and provides an overall picture of the business’s health.
3 Types of Cash Flows
Before we walk you through cash flow statements, let’s look at the various types of cash flows:
Cash flow from operations (CFO)
Cash flow from investing (CFI)
Cash flow from financing (CFF)
1. Cash Flow from Operations (CFO)
Cash flow from operations (CFO) refers to the cash generated or used by a company's core business operations over a given period. SaaS CFO inflows include revenue from subscriptions or long-term contracts and revenue from services. SaaS CFO outflows include business expenses such as salaries, marketing costs, research and development expenses, hosting fees, and customer support costs.
CFO is similar to but not the same as the revenue and expenses found on your income statement, which summarizes all the funds that have entered and left your business. Revenue recognition rules (ACS 606) might show revenue you’ve earned that you haven’t received or, similarly, expenses you haven’t yet paid.
2. Cash Flow from Investing (CFI)
Investing cash flows (CFI) involve the sale or purchase of long-term assets, such as property, equipment, securities, and acquisitions. These cash flows show how a company is allocating its capital for long-term growth. CFI inflows include cash generated from the sale of long-term assets, securities, or other business ventures. CFI outflows include cash paid to acquire new technology, equipment, or other assets necessary for operations.
3. Cash Flow for Financing (CFF)
Financing cash flows (CFF) are transactions involving debt, equity, and dividends. These provide insight into the company's capital structure by showing how the company is obtaining and repaying its capital. CFF inflows include any cash from issuing stock, taking on loans, or other financing activities. CFF outflows include debt repayments, dividends paid to shareholders, and cash used to repurchase stock.
Types of cash flows shown in a cash flow statement:
How to Prepare a Cash Flow Statement
A company’s statement of cash flows is a financial document that summarizes the cash inflows and outflows for a specific period. It can provide a comprehensive picture of how the business is managing its day-to-day resources.
A SaaS cash flow statement follows the same format that most businesses use; however, a SaaS business must consider when subscription revenue is recognized over the contract period and how to capitalize software development costs. It's best to use the indirect method and accrual accounting practices to prepare your statement.
Follow these six steps to prepare a cash flow statement for your SaaS business:
1. Collect financial data
Make sure you have all relevant financial data for the given accounting period. This includes your income statement, balance sheet, and any other pertinent financial reports.
2. Organize inflows/outflows
Categorize your income and payments — CFO, CFI, or CFF — then calculate the net cash flow for each category by subtracting cash outflows from cash inflows.
3. Calculate total cash flow
Summarize the net cash flows from operating, investing, and financing activities to arrive at your net change in cash for the period.
4. Adjust for non-cash items
Common non-cash items are depreciation and amortization. Adjust your net cash flows to account for these non-cash items. These adjustments are typically made in the operating cash flow section.
5. Prepare the cash flow statement
Organize the calculated figures into the standard cash flow statement format. The statement typically starts with net income, followed by adjustments to reconcile net income to net cash flow from operating activities. Then, present the cash flows from investing and financing activities, finally arriving at the net increase or decrease in cash for the period.
6. Ensure accuracy
Review your calculations and data entry to verify that everything is accurate and adheres to the required accounting standards and guidelines. Any mistakes can lead to misrepresentations of the company's financial health. Many startups consult with a professional accountant or advisor familiar with SaaS industry accounting practices to ensure accuracy and compliance.
Example Cash Flow Statement
Analyzing Cash Flow
Analyzing your startup’s cash flow gives you and potential investors insight into your company’s financial health and stability. Once you’ve prepared your cash flow statement, you can perform a cash flow analysis to understand where cash is coming from and where it’s going. This crucial financial information tells you how well your business is generating cash and how much you have on hand to pay the bills and invest in growth.
How to do a cash flow analysis
Your cash flow is the net cash amounts from operating, investing, and financing cash flows — it’s the calculation at the bottom of your cash flow statement showing the net change in cash for the period. After you’ve determined whether you have positive, negative, or breakeven cash flow, you can compare outflows against inflows to draw conclusions about how you're managing your cash. You can then make changes as needed.
Ideally, you should look at the previous 6 to 12 months when analyzing cash flows. If you’re using accrual accounting, you can perform your analysis with a 12-month average of your net operating cash flow, which controls for seasonality and accounts for capitalized software.
Below are three methods for analyzing cash flow:
Free Cash Flow (FCF) Margin
This calculation shows you the proportion of revenue that becomes free cash flow (FCF). The margin indicates how efficiently your business converts generated revenue into free cash flow. The higher your FCF margin, the more cash is available to reinvest in operations.
Formula
FCF Margin = (Operating Cash Flow – Capital Expenditures) ÷ Revenue
Cash Flow Coverage Ratio
The cash flow coverage ratio is calculated by dividing operating cash flows by total debt. A high ratio indicates that your business has sufficient cash flow to pay for scheduled principal and interest payments on its debt.
Formula
Cash Flow Coverage Ratio = Net Operating Cash Flow ÷ Total Debt
Operating Cash Flow to Net Income Ratio
Investors often use this ratio to justify a company’s performance. The Operating Cash Flow to Net Income ratio shows how much cash is generated for every dollar of sales. It’s a more reliable metric than net profit. Generally, the higher the ratio, the better. If cash flow increases at about the same rate as sales increases, the business is healthy and sustainable.
Formula
Operating Cash Flow to Net Income Ratio = Net Operating Cash Flow ÷ Net Sales (or revenue from your income statement)
Improve SaaS Cash Flow Using Revenue-Based Financing
This non-dilutive debt capital is ideal for SaaS startups with higher gross margins and recurring revenue. Payments are based on your future revenues, so they won’t deplete your cash as you repay the debt when business is slow. You can also use revenue-based financing to invest in key hires or marketing initiatives that help you expand your SaaS business faster.