In the last article, we covered Concepts and terminologies related to Markets and users which are crucial to understand before any investor starts investing in a particular company.

In this article, we’ll discuss the Financial Concepts & terminologies related to a business, signifying the financial health of a business. Understanding the financial health of a business is equally crucial, if not more. Firstly, it provides a comprehensive insight into the company's profitability, liquidity, and overall stability, allowing investors, stakeholders, and management to gauge its ability to generate sustainable revenue and weather economic uncertainties.

Secondly, a thorough analysis of financial statements helps in assessing the company's risk profile, enabling investors to make informed investment decisions based on their risk tolerance and objectives.

Like always, we’ll try to start this concept in the form of a story to help our users get a comprehensive understanding of the subject:

In the bustling startup hub of Mumbai, seasoned angel investor, Aisha, found herself intrigued by a young fintech startup called "FinVista." The founders, Raj and Ananya, exuded passion for their digital financial solutions platform, and Aisha sensed the potential for a transformative journey. However, she also observed a gap in their understanding of critical financial concepts.

Recognizing the need for guidance, Aisha decided to mentor Raj and Ananya. The first lesson was on "Burn Rate," a term that Raj and Ananya hadn't fully grasped.

Burn Rate: Aisha explained the importance of managing expenditures vis-a-vis income, and the founders realized the significance of optimizing costs to achieve sustainable growth.

Burn Rate, in the case of Startup companies, is the rate at which a new company is spending its venture capital to finance its overhead before generating positive cash flow from operations. Thus, the Burn Rate can be considered a measure of the negative outflow of the business.

Burn Rate can be divided into 2 types:

Gross Burn Rate: Gross Burn Rate is simply the money spent by the business every month or in other words the total monthly cash outflow. It is generally calculated by combining all your monthly expenses as found on your income statement inside your P&L sheet.

Net Burn Rate: Net Burn Rate is the amount of money lost each month and takes into account possible company revenues. In other words, it signifies the difference between monthly cash inflows and cash outflows.

Let me give you examples of a couple of companies to help you understand better the concept of burn rate:

Airbnb: In the early days, Airbnb had a high burn rate as it invested heavily in marketing, growth, and product development. However, they were able to achieve profitability by focusing on revenue-generating activities and cutting back on non-essential expenses.

Uber: Uber also had a high burn rate in its early days, as it invested heavily in expansion and marketing. However, the company was able to achieve profitability by scaling its operations and cutting back on driver incentives and other expenses.

Runway: Next on the agenda was "Runway." Aisha painted a vivid picture of a startup's financial runway—the time it could stay afloat before running out of funds. Raj and Ananya began to see their startup's trajectory as a flight, and the concept of maintaining a sufficient runway period resonated deeply. It was a paradigm shift in their financial mindset.

Runway, popularly known as Cash runway, is a term used to imply the amount of time, in months a business has before it runs out of cash. It can be calculated by dividing the current cash balance by the cash burn rate.

Let's understand the concept of Cash Runway with the help of examples:

Pharmeasy: Recently we heard that Pharmeasy, which had earlier planned to launch its IPO in 2023, had delayed the process till 2025 due to some concerns with its high cash burn rate which was leaving a decreased Cash runway for the company that had the potential to badly impact their proposed IPO, since that would create a negative perception about the company’s financial management in the eyes of the investors.

Cash Burn Rate: The discussion then shifted to "Cash Burn Rate." Aisha emphasized the need for efficient cash management, urging the founders to understand how quickly their startup was using up its available cash. The realization dawned on Raj and Ananya that controlling their cash burn rate was paramount for longevity.

Cash Burn Rate signifies the change in Cash balance month over month. It is calculated as the difference between the Cash balance in the prior month & Cash Balance in the current month.

Meesho: Take for instance the case of the popular online women's clothes shopping business Meesho which has recently achieved a milestone by reducing its cash burn by 90% in the last year. This is in line with the company’s aim to become EBITDA positive.

CM Level 1, CM Level 2, CM Level 3: The discussion then turned to Contributing Margin (CM). Aisha emphasized the crucial role of Contributing Margin—highlighting that it represents a product’s net sales minus all associated variable costs. The total contribution margin represents the total amount available to pay for fixed expenses and to generate a profit. It can be further divided into CM1, CM2, and CM3.

CM Level 1: CM Level 1 represents the Sales (revenue from Operations) minus the basic cost of goods sold, discounts, and coupons. This is the same as the Gross margin.

CM Level 2: Under CM Level 2, we deduct any other Operational Variable Costs which include logistics warehouses, payment gateway fees, etc. All these are also known as Indirect Expenses in the field of finance.

CM Level 3: Lastly, we arrive at CM Level 3. Under CM level 3, we deduct the marketing & administrative expenses. In other words, CM level 3 can be regarded as deducting direct costs from EBITDA.

Understanding and optimizing this metric is key to sustainable business growth and financial success.

EBITDA: EBITDA is the net income with interest, tax, depreciation and amortization added to it. EBITDA is generally used by companies, on the one hand, to track and compare the underlying profitability of companies regardless of their depreciation, assumption & financing choices & by investors on the other hand to see how well is the firm being managed.

PAT: PAT on the other hand refers to the amount that remains after a company has paid off all of its operating & non-operating expenses, other liabilities & taxes. This profit is either distributed among the shareholders as dividends or kept as retained earnings to be invested back into the business for further expansion.

Royalty: Royalty is akin to renting out special rights. In startups, royalty is a way to get money from investors. Instead of giving up ownership, investors get a part of the startup's future revenue. This helps startups grow while still keeping control of their company.

Let’s take an example from Shark Tank to understand this better. The first startup that appeared on Season 3 of Shark Tank, The Honest Home got a deal from Sharks as a part of which they had to give 1% Royalty per unit of sales until Sharks got ₹1.5 Cr. returns which was 1.5x the invested amount. So supposing The Honest Home is selling a unit of eco-friendly daily-use product for ₹500, they pay ₹5 to Sharks who had invested.

Ramen Profitability: Ramen profitability refers to a business's ability to generate only enough profit to cover the founders' basic living expenses, reminiscent of the low-cost lifestyle often associated with instant ramen meals. While this term underscores the importance of profitability, it also highlights the limitations of generating just enough income for sustenance.

However, for startups aiming for long-term success, relying solely on "ramen profitability" is not sustainable. Instead, founders should aim for "traditional profitability," where the business generates sufficient profits to support a comfortable and viable standard of living for the founders, reflecting the success of their sales efforts.

Churn Rate: Lastly, Aisha delved into "Churn Rate." As she explained how customer churn impacted the business, Raj and Ananya started dissecting their user base. Understanding the nuances of customer retention became a key focus, with the founders realizing that sustaining customer loyalty was as crucial as acquiring new users.

Churn Rate, commonly known as the Rate of Attrition is the rate at which customers stop doing business with the entity. It is most commonly expressed as the percentage of service subscribers who discontinue their subscriptions within a given period of time.

Many companies look towards the Churn Rate to assess their performance as an entity. Infact many wholesalers also use this metric to check how efficient their after-sale services have been. Let’s look at an example of a company that had a very high churn contributing to their decreased revenues:

VI (Vodafone-Idea): VI or Vodafone-Idea, India’s 3rd largest telecom player in the market has been assessing its performance year on year using a Churn Rate that has been decreasing for a while now & a report by ICICI securities has cautioned them that if they don’t arrest this collapse in churn rate, they will be left at the 4th position in the telecom market in terms of active subscribers thus resulting in further increase of losses.

Armed with this newfound financial literacy, Raj and Ananya transformed their pitch deck. They confidently presented to potential investors, including Aisha, showcasing a deep understanding of their startup's burn rate, runway, cash burn rate, and churn rate. The language of finance had become their ally, and it resonated with investors looking for not just promising ideas but also a solid financial foundation.

As "FinVista" secured funding, Aisha beamed with pride, knowing that the journey had extended beyond mere investment—it was a journey of education and empowerment. The story of FinVista and Aisha became a beacon in the Indian startup ecosystem, emphasizing that for angel investors, a founder's grasp of financial concepts was as crucial as the innovation behind the business.