Burn rate, the rate of depletion of a company’s cash pool, is a key aspect in the sustainability of a company. It is the rate at which a company exhausts its cash pool in a loss-generating scenario. Companies, including startups, use this as a common metric of performance and valuation.
Why You Should Not Let the Burn Rate Burn Your Company
For startups, since the focus on the early stages is to grow their customer base and improve their products or services, they are unable to produce a positive net income yet. Generating profit from sales or revenue for startup companies may take years (with some companies in the technology and biotech industries, for example, sometimes face years of living on their bank balances). Thus, the need for them to have an adequate supply of cash on hand for their daily operational expenses. This is where the seed stage investors or venture capitalists come in as they can provide funding the startup company. But this is based on the company’s burn rate.
Burn rates are also applicable to mature and struggling companies who carry excessive debt. A company that burns cash too fast is at the risk of running out of money and going out of business. When a company doesn’t burn enough cash, it might mean that investing in its future is at stake and they may fall behind the competition.
When a company’s cash burn extends over a period of time, most likely, they are operating on borrowed capital and stockholder equity. When a company is seeking for additional capital, investors specifically need to check on the company’s burn rate. Factors that investors consider before investing are the company’s available cash, their capital expenditures, and their burn rate.
How to Compute for Burn Rate
With a cash flow statement at hand, calculating for burn rate is straightforward.
Burn Rate = (Starting Balance – Ending Balance) / # of Months
For example, you were able to acquire $1 million funding from investors. As you start spending the money, you will realize that you cash balances also begin to deplete (once you start hiring employees, buying equipment, changing offices, etc.). Your next strategic step is to be vigilant about what you spend on and seek more funds. It’s important that you closely monitor your burn rate to make sure that your cash reserve does not quickly shrink.
Now, assuming that before you receive additional funding from your investors, you already have $300,000 in the bank (which means that your starting cash balance is $1.3 million). After five months, you realized that your cash balance has dropped to $700,000. Based on the formula for burn rate, this means that your business is losing $120,000 per month.
($1,300,000 – $700,000) / 5 months = $120,000
When computing for burn rate, it is ideal that you select a period that is long enough so you will get an accurate average. Using one or two months worth of data is not enough as any variation in spending may result to an imprecise reading of how quickly you spend money.
There are also differences on the burn rate computation that would give additional spending insights.
Gross Burn Rate: This is the company’s operating expenses (including the fixed and variable costs). It is computed as the sum of all operating expenses that are often measured on a monthly basis (i.e. rent, salaries, other overhead costs). Not considering the company’s revenue, the gross burn rate provides insight of the cost drivers and efficiency of a company.
Gross Burn Rate = Cash / Monthly Operating Expenses
Net Burn Rate: This is the rate at which a company is burning money. It is computed as the difference between its operating expenses from its revenue (also calculated on a monthly basis). This metric shows the amount of money that the company needs to continue its operation for a period of time. The variability in revenue (an indicator of financial performance that takes a company’s current revenue in a certain period and converts it to an annual figure to get a full-year equivalent) needs to be controlled as a dip in the revenue without having changes in costs can result to a higher burn rate.
Net Burn Rate = Cash / Monthly Operating Losses
To determine if the company is really in trouble, you have to compare the burn rate with the working capital (the company’s current assets like cash, accounts receivables, inventory less the company’s current liabilities which includes accounts payables) and measure it over the same period. The working capital metric is used to measure a company’s short-term financial health.
What a High Burn Rate Suggests
When a company depletes its cash supply at a fast rate, there’s a higher chance that it will experience a state of financial distress. With this, investors would need to be belligerent in setting deadlines for them to realize revenue or they would need to inject more cash into the company to give ample time for it to reach profitability.
Determining Cash Runway Using Burn Rate
Burn rate is indeed a key aspect in determining cash runway. Cash runway tells you how long your business can continue operating at such rate before depleting all funds in your bank account.
Cash runway is computed as:
Cash Runway = Current Cash Balance / Burn Rate
Using our previous example, if your startup has $700,000 in cash remaining and has a burn rate of $120,000 per month, this means that you’ve got about six months of runway (or the time until you run out of cash).
$700,000 / $120,000 = 5.83
Now, let’s use a larger-scale example (since majority of startups are dealing with bigger amount of money).
Startup A raised $10 million (which brings their cash balance to $11.5 million in total). In the next three months that they are operating, they are losing $250,000, $300,000, and $275,000, respectively.
To compute for Startup A’s burn rate, we need to compute first the total losses (which is the $250,000 + $300,000 + $275,000). Total losses is $825,000. This leaves a total of $10,675,000 left in their bank account.
Let’s now insert the significant numbers into our burn rate formula.
(Beginning Balance – Ending Balance) / # of Months
($11,500,000 – $10,675,000) / 3 = $275,000
Now we know that Startup A’s spending is at $275,000 monthly, we can now compute for their cash runway.
Current Cash Balance / Burn Rate
$10,675,000 / $275,000 = 38.81 months
Given the rate at which Startup A is spending, this means that they have a cash runway of under 39 months. Ideally, startups seek additional funding within one year. Given the cash runway of Startup A, this means that there’s room for them to increase spending and investing in initiatives that would drive their profitability.
With burn rate and cash runway going hand-in-hand for startups, these metrics provide businesses a better understanding of how quickly they are spending money and the timeframe in which they can continue doing so. These figures also give businesses a good analysis of the adjustments they need to make to hit their goals.
Burn Rate for Startups and Established Businesses
While burn rate is a crucial metric for both startups and established businesses, the way they are being assessed may not be the same. Startups use burn rate to make sure they are using the invested money to good use, while established businesses use this metric to make sure that they stay afloat.
Burn Rate for Startups
It usually takes years for startups to become profitable on their own (most especially those in high-growth industries) so reliance on venture-backed investments is common among startups in stimulating their growth and development. They often need a number of rounds of funding to reach profitability (as getting a huge amount does not happen right away). The ability of the startup’s leadership team in fund management is in question if they spend the invested amount too quickly.
Aside from investor optics, startups can better plan ahead using burn rate as a measure on when it is necessary to seek additional funding. It usually takes 12 to 18 months for each round of funding to occur with each round capable of sustaining a startup for a minimum of one to two years. Sometimes, startups can secure additional funding between six to nine months. As soon as funding is received, it would only take a few months for startups to hit the fundraising track again. It is the burn rate figure that would help you identify the right time to get back out there.
Burn Rate for Established Businesses
Even if established business does not seek for venture capital funding, it is still important for them to monitor burn rate so they know if they are operating at a loss. Along with cash runway, burn rate can help established businesses identify how long they can carry on with their operations at a loss before shutting down. Simply put, burn rate sets the stakes for how immediately they need to seek for a solution and boost revenue.
Ways to Reduce Burn Rate
Whether you are a startup which has a high burn rate or a small business that experienced a few difficult months and is in the rebound phase, here are some useful tips that would help in reducing your burn rate (or maybe totally get rid of it).
Analyze Your Financial Reports
You have to collect your financial reports for the last few months and carefully analyze them. Check if there are changes in revenue or spending. If there’s any, identify when they happened and which area of the business needed them. Reviewing your financial reports reveals so much about what’s happening in your business.
Specifically for startups, minimizing costs is the most useful switch to pull if you aim to adjust burn rate. Evaluate your COGS (cost of goods sold) and operating expenses carefully to check for irrelevant spending that could be eradicated.
Consider Selling Assets
Check your assets and see if there’s anything that can be liquidated for additional cash.
When well-established and small businesses look for ways to boost revenue, it’s for a better long-term fix rather that just minimizing costs. Assess your marketing and sales strategies and try on some novel ideas first before considering selling assets or cutting expenses.
Financial Modeling & Valuation Application of Burn Rate
The monthly burn rate should be emphasized whenever you are trying to build a financial model for a start-up company (or a business on its early stage). This is of key importance until the next financing is required.
Businesses in their early stages usually raise funding in phases to finance the different stages. The burn rate is crucial here because it helps in highlighting how the company can survive until additional funding is needed.
Know Your Company’s Burn Rate
Knowing your company’s burn rate and cash runway is essential in establishing your spending strategy and in achieving your goals.
Read this blog article if you want more to better understand how to effectively manage cash burn. Feel free to reach out to us at Credo team for a thorough and honest burn rate analysis that would help your business reduce overruns and improve your organization’s chance for success.
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