One of the causes that lead to the failure of startups is running out of money. Eighty-two percent of startups fail due to cash flow problems. Therefore, understanding the concept of cash burn rate is key to surviving in the business world.
However, this doesn’t mean that only startups need to worry about burn rate. All businesses need to calculate their burn rate to understand how quickly they spend their cash reserves and when they need corrective action.
Mature businesses also need to pay attention to their burn rate. It serves as a warning sign that indicates when the company is heading into uncharted waters.
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Put simply, burn rate is the amount of money a company spends each month. It measures how quickly a company is depleting its cash reserves. It can be measured in cash or the equivalent of cash costs such as salaries, rent, and technology spending.
Burn rate helps you identify how much cash you need to maintain your business operations. If the burn rate is too high, it can mean that you are running out of money too quickly and need to take corrective action.
Do you need to stop spending on advertisements? Are there certain expenses that can be reduced? Analyzing burn rate helps you answer these questions and make informed decisions accordingly.
Generally, a high burn means that the company is spending beyond its limits and needs to be more mindful of its cash flow. However, it’s important to note that a high burn rate isn’t always alarming. Sometimes, companies intentionally set a higher burn rate to achieve rapid growth or to invest heavily in research and development. In these cases, they may have the funds to sustain a higher burn rate and use it to their advantage.
Also, a high burn rate can be a sign of success. For example, your burn rate would increase significantly if you invest in your business by hiring more employees or launching a new product. But if you are spending money without increasing your revenues, that is when you have to worry about the sustainability of your business.
Therefore, it is important not to look at the burn rate as a standalone metric but rather to consider it in the context of your overall business strategy.
When calculating burn rate, it is important to distinguish between gross and net burn rates.
Gross burn rate refers to total monthly expenses, including both operational and one-time costs such as employee salaries and rent.
Net burn rate, on the other hand, is a measure of how much cash you are burning each month after taking into account any non-recurring income. This is the number that most businesses use to track their burn rate since it gives an accurate picture of their cash flow.
Tip: If a business has positive cash flow, breakeven, or negative cash flow, then it should calculate the gross burn rate. The net burn rate is calculated when a business has negative operating cash flow.
The gross burn rate tells you how your company is doing overall regarding cash flow without considering your revenue streams. To calculate the gross burn rate, you add your monthly expenses, such as employee salaries and rent, to get a total. Then divide by the number of months.
For example, if a company’s monthly expenses are $50,000 and its total starting cash balance is $250,000, its gross burn rate would be $50,000.
Gross burn rate = ($50,000)/1 month = $50,000
On the other hand, the net burn rate takes into account income generated from non-recurring revenue streams such as investments and sales.
To calculate the net burn rate, subtract all non-recurring income from the monthly expenses. Then divide that number by the number of months to get the net burn rate. Simply take the starting balance less the ending balance and divide it by the number of months.
For example, if a company’s monthly expenses are $50,000 and its total starting cash balance is $250,000, but it also brings in a non-recurring income of $20,000, its net burn rate would be $30,000.
Opening balance = $250,000
Closing balance = ($250,000 – $50,000) + $20,000 = $220,000
Net burn rate = ($250,000 – $220,000)/1 month =$30,000
Calculating and interpreting your burn rate can help you make informed decisions about your cash flow and better manage your expenses. It’s important to keep track of both gross and net burn rates to get an accurate picture of your finances.
Remember cash burn rate is a point-in-time calculation. It, therefore, makes sense to calculate it periodically, such as monthly or quarterly.
It is recommended you calculate it over a period of months to avoid getting an inaccurate picture of your business’s cash flow, as one month’s expenses or income could be much higher or lower than the average.
Let’s look at an example of a company that is calculating its burn rate:
ABC Corporation, on March 1, had a starting balance of $100,000 in cash.
During March, ABC Corporation had total operating expenses of $40,000 and received income from sales of $30,000.
So, at the end of March, ABC Corporation had a cash balance of $90,000.
In this scenario, ABC Corporation’s gross burn rate would be $40,000, and its net burn rate would be $10,000.
Gross burn rate = Expenses/no. of months
=($40,000)/1 month = $40,000
Net burn rate = (Starting balance – Ending balance)/no. of months
= ($100,000 – $90,000)/1 month = $10,000
Now let’s say, after three months of tracking, ABC Corporation’s closing cash balance each month was as follows: $90,000 (March), $80,000 (April), and $60,000 (May) with expenses of $40,000 each month.
In this case, ABC Corporation’s gross burn rate would be $40,000, and its net burn rate would be $13,333.33.
In addition to understanding the difference between gross and net burn rates, it’s also important to consider its relationship with cash runway.
Cash runway is the amount of time a company can sustain its current level of operations using only the cash on hand. It’s calculated by taking the total cash balance and dividing it by the burn rate.
For example, if a company’s total cash balance is $250,000 and its burn rate is $16,000, it has a cash runway of 15.6 months ($250,000 / $16,000 = 15.6).
Knowing the cash runway can give you an idea of how much time you have to get your company back on track before running out of cash. It’s important to monitor these metrics regularly and plan accordingly.
In the case of a mature business, for instance, bad economic conditions, changes in the market, or other events can affect your cash flow. You might take a loan or a line of credit to curb this.
Therefore, calculating the burn rate and cash runway can help you make informed decisions about your cash flow, better manage your debt, and anticipate future needs.
As every business is different, there’s no one-size-fits-all answer to this question. However, in general, it’s recommended that startups, seed-stage, and Series A-stage companies should aim for 12-18 months of runway.
This may vary depending on your industry, the size of the business, and other factors. It’s important to note that the cash runway is a sliding scale. The longer it is, the more flexibility you have when making decisions that affect your cash flow.
A longer runway also gives you more time to make corrections if your business isn’t performing as expected. On the other hand, a shorter runway could put you in a difficult position if things don’t go as planned.
Generally, a low cash burn rate is ideal. This gives you more time to make changes, adjust your strategy, and achieve profitability.
If you’re looking to reduce your burn rate, there are several strategies you can use. These include:
The cash burn rate is a fundamental metric. Even potential investors look at this metric when evaluating a business. Knowing how to calculate burn rate, its relationship with cash runway, and how to reduce it can help you make informed decisions about your cash flow and put you in a better position to succeed.
Be proactive with cash flow management, whether you are a startup or a mature business. Doing so can help you stay on top of your finances and increase your chances of success.