About 80% of startups fail to stay on top because of improper planning and cash flow control. Cash Burn Rate is one of the key indicators for creating and adjusting business strategies, especially for junior businesses. Cash Runway is determined on the basis of this figure, that is, it is the possible duration of existence of the business with its cash reserve. This is especially important in times of crisis, particularly during a pandemic or war.
What’s the story about?
- What is a Cash Burn Rate?
- Types of Burn Rate and formulas to calculate
- What is a Cash Runway?
- Why count the investment burn rate?
- How to reduce the Burn Rate?
- Conclusions
What is the Cash Burn Rate?
Cash Burn Rate is a metric that represents the rate of financial spending by a business. As a rule, it is based on the amount a company spends per month. Financial analysts determine the viability of a business plan based on the Burn Rate, because it shows whether investments are profitable and whether it is worth cutting costs and increasing profits before the company goes bankrupt.
Partners and investors in startups pay attention to the Burn Rate. It is this value, not the net profit or the number of orders, that determines the viability of a business.
For some time before the pandemic, there was a tendency to grow and scale rapidly, no matter what. However, quarantine, a drop in demand, and in our country also a war with numerous legislative changes, forced entrepreneurs to adapt to the new conditions or close down.
Prudent business owners who took care of the emergency fund in advance were not only able to continue operations, but also in the future to receive or even increase profits.
“The cost level is the rate at which a company loses money. It is usually expressed in monthly terms. For example, a company’s burn rate is now $65,000 a month. In this sense, “burn” is synonymous with negative cash flow. It is also a measure of how quickly a company is using up its equity capital. Burn rate, Wikipedia
This metric is also called negative cash flow or the dynamics of the expenditure part of the budget. At the initial stages of operations, the vast majority of startups do not generate profit, because all of their resources are aimed at improving the product and its promotion. The Burn Rate directly affects the allowable “runway”: the period that a company has to run out of operating capital. If the Burn Rate is too high, the duration of this “maturation” should be short.
Various factors affect the burn rate of an investment — it’s the right strategy, and the company’s ability to implement its plan if it maintains the right cash reserve, and support business stability in case of emergency.
📌 Read the blog: How to Calculate ROI, ROAS and ROMI
Types of Burn Rate and formulas to calculate
There are two types of ratios: gross (Gross) and net (Net). Gross ratio is the total amount spent by the company in a month. The net indicator is the amount of money spent during the month, including income.
To get the Gross Burn Rate, divide the expenses by the number of months the business has been in operation. Gross Burn Rate is equal to the sum of total operating expenses — rent, wages of employees, equipment, materials, etc. And when calculating the net Burn Rate, you should subtract the company’s income for the period under study from the resulting gross rate.
A company’s net burn rate is the total amount of money a company spends each month. It cannot be more than gross, but it can be less. Burn Rate: What It Is, 2 Types, Formula, and Examples, Will Kenton
For example, if a tech startup spends $5,000 a month on rental of an office, $10,000 on monthly server costs, and $15,000 on engineers’ salaries, its gross would be $30,000.
Suppose that the above-mentioned company, with gross expenses of $30,000, also has income from the sale of goods of $20,000 per month and expenses for those goods of $10,000 per month. The company’s net expenses would be $20,000, which is calculated as follows:
($20,000 – $10,000) – $30,000 = -$20,000
The ideal Burn Rate is no higher than 8-9% of the overall cost. Otherwise, we may conclude that the company wastes funds too quickly. Consequently, this leads to the layoff of employees, loan processing, the urgent search of new investors, or even bankruptcy and liquidation of the business or sale of it.
Care must be taken to ensure that the Burn Rate is solid relative to income. If a company is growing rapidly and often attracts new investors, partners, and clients, a slightly inflated expense ratio may be acceptable. But in the case of a slow-growing business, the burn rate should not exceed the generally accepted norm of 8-9% of the budget.
What is Cash Runway?
Cash Runway is another important indicator of business profitability — a metric closely related to the Burn Rate. Cash Runway shows how long the business has enough money at the current rate of spending.
The cash flow in the charts is usually represented by a line crossing the graphical symbols of the net Burn Rate.
Cash Runway is calculated using the current cash balance divided by the monthly operating expenses.
“For example, your starting balance is $180,000. Your net expenses are $12,000 per month. Below is a calculation of your runway.” Source: Cash Runway
$180 000 ÷ $12 000 = 15 months
The optimal Cash Runway is considered to be 12 months. This means that at this rate a completely unprofitable company can function for exactly one year. The business can gain new sources of income and balance the budget during this time. The low burn rate of financial resources makes the company flexible and sustainable. This kind of business reacts instantly to market changes and adapts well to crises.
What is the investment burn rate for?
The Burn Rate and Cash Runway measures how much money a business needs to function for a month with current revenues and expenses, and how long a business can exist with no investment at all.
“Awareness of the Burn Rate is key both for recognizing the areas for improvement in your business and for planning for the future. Especially if you’re a funded startup, you can’t ignore the Burn Rate.” Source: Burn rate: What is it, why does it matter, and how to reduce It.
Calculation of the “cash flow” helps to reach the profitability point, after which the business can probably function regardless of external circumstances. Temporary investments and one-time income do not play a major role in this, only postponing the critical moment. Therefore, the calculations should be based on the average income and expenses of the business.
Monthly Burn Rate and Cash Runway recording in the form of charts will help you track positive and negative changes in the financial position of the company and in time to correct deficiencies in the system.
Of course, some deviations from the expected results are normal. A business can go through crisis situations, sometimes spending more on scaling and overcoming difficulties. It is worth making every effort to ensure that such fluctuations do not have a permanent effect on the Burn Rate and Cash Runway. Financial reserves designed for contingencies, cooperation with other companies, investing, and other things can help in this case.
The importance of burn rate for business can be compared to keeping a list of expenses and planning a family budget. A financial cushion, such as a deposit, allows you to scale up (to buy something significant) or get out of a crisis situation (to relocate out of the country or out of the city, if necessary).
“Burn Rate also depends on how quickly people spend their money, particularly discretionary income. For example, Mackenzie Investments commissioned a test to assess Canadians’ spending and saving behaviour to determine whether they are “spenders”.
In addition to funding, the term burn rate is also used in project management to determine the rate at which time is used on a project, to identify when work is out of scope or when efficiency is lost. Simply put, the burn rate of any project is the rate at which the project budget is spent.” Burn rate, Wikipedia
How to reduce the burn rate?
For a startup, it is important to allocate enough time to create the company model and processes, financial planning, taking into account all possible risks. This also applies to businesses that are resuming activities in new markets, or simply changing direction or launching new projects. Scaling can wait — it is essential to calculate how much money you may need in a month, six months, a year.
A company’s level of spending is often indicative of overspending. Typically, extra money goes to branding and office space, and is spent in improperly built relationships with vendors, customers, and tenants. Review prices, look for new partners, move employees to a more modest office if you notice that you will soon need a loan for staff salaries.
“If you’re not prepared, scaling too quickly can be dangerous — it can lead to failure instead of success.” Is Your Company Dangerously Rushing To Scale? — Young Entrepreneur Council (YEC)
The Burn Rate has a big impact on business. If it is overstated, it is worth correcting the situation, which can be done in several ways or a combination of ways.
- Concentrate on the company’s main areas or on a unique product. A variety of services, offerings, and products is not always beneficial to the entrepreneur. Identify a number of core services or products that are in high demand in the marketplace and are good for you, and lower your Burn Rate by focusing all your resources on your strengths.
- Create mediate company aim. Determine targets, create a realistic timeline, and then manage your money according to those targets. It’s important to reach the intermediate milestone before you run out of resources, and then work in a similar pattern over and over again. Intermediate goals make it easier to get things done.
- Outsource as many functions as possible, especially non-core ones such as accounting, finance, and HR. This way you do not have to hire a lot of specialists, train them, buy equipment, software, etc.
- Do not be afraid to close projects that have lost their relevance and are unlikely to bring significant profit in the future.
- More radical methods are staff reductions or wage cutting. An alternative is to switch employees to remote work, if possible.
- Very often the best and fastest way is to move. Perhaps you are spending too much money on rent and utilities. Try to set up an office or store (warehouse, production) in a more budget-friendly location, perhaps away from the downtown area.
Frequently Asked Questions
This is a measure of the rate of financial expenses of the business. Burn Rate is calculated based on monthly expenses data. For investors, the Burn Rate shows whether the investment will be profitable and how far the company is from bankruptcy.
Cash Runway is a financial metric that shows how long you have enough money at your current cash reserve burn rate. Cash Runway is calculated based on monthly expenditures.
Burn Rate = Costs ÷ Months
Conclusions
- Regular monitoring of spending levels focuses attention on areas of your business that need to be rethinking. Before scaling your company, determine your Burn Rate and Cash Runway metrics and take appropriate action if the metrics turn out to be negative.
- Growing a business requires positive cash flow, so create a plan from the beginning to help you understand how and when you can reach a Burn Rate of up to 8-9% of your total budget and a Cash Runway of about 12 months.
