For startups and growing companies, burn rate can mean the difference between thriving for years and closing up shop. This is a critical metric for any investor who may be thinking of backing your business. It is also often misunderstood and underestimated by those who should be paying attention to it the most.
Here’s what you need to know about burn rate, including what it is and why it’s important—and how to calculate yours and determine if it’s where it should be.
What is burn rate?
So what is a burn rate? The burn rate, also known as the “cash burn rate,” is the rate at which a company spends cash, usually calculated as a monthly average. For example, if a company spends an average of $12,000 per month, the company’s burn will be $12,000.
It is also a key indicator of the company’s overall financial health. Knowing how much you spend each month and how much cash you have on hand can help you make better financial decisions and communicate more effectively with investors.
What is a burn rate strategy?
Your burnout strategy directly affects how you run your company. When you carefully monitor and use metrics to make operational decisions, you are using a burn rate strategy. A good strategy will help you determine the following:
- The size and scope of your budget
- Cost planning
- Money saving opportunities
- How long will your company take to raise a new round of funding?
- Prioritize fundraising sooner rather than later
First of all, knowing your burn rate is essential in determining your cash runway.
What is Money Runway?
“Cash Runway” refers to how much time a company has before it runs out of cash. This is a projection based on the organization’s cash stores and average monthly burn rate. Calculating your cash runway is an important next step.
How to calculate burn rate
The formula is a simple average of the company’s monthly expenses.
To calculate your average monthly burn rate per year, subtract your current cash flow from your starting cash flow, then divide by 12.
For example, if your company had $500,000 on January 1 and $200,000 on December 31, your burn rate is $25,000:
($500,000 – $200,000) ÷ 12 months = $25,000
Note that you can calculate with or without income included in the equation. A “with revenue” calculation can help you understand the long-term viability of your company’s spending habits. “No revenue” is a worst-case scenario calculation that indicates how long your company would survive if all of your revenue streams suddenly stopped.
Cash Runway Calculation
To determine your company’s cash runway, divide your cash on hand by your burn rate. Using our example above, this means that a company with $200,000 in the bank and burning $25,000 has a cash runway for eight months:
$200,000 ÷ 25,000 = 8 months
Note that the cash runway calculation assumes that the company will not raise additional cash and will not experience a drastic change in its financial position. This is what makes Cash Runway a fundamental benchmark. The “break-even” forecast indicates how long a company could survive without generating any revenue.
What is the right burn rate for your company?
Regardless of its situation, any company should have a burn rate that provides at least six months of cash runway. Less than that, and you may not be prepared for sudden changes in income or expenses (which is why it’s so important to learn how to calculate it).
In other words, your monthly expenses should never fall below the minimum level of capital you need to operate your business for the next six months.
Of course, every company is different. A financial strategy that works for one startup may be a major mistake for another. Consider plotting your burn rate in terms of growth and deepen your awareness by exploring specific metrics such as “burn per new hire” or “burn per department.”
If you can afford to start a period of growth, then increase your burn rate for a while and spend some money on growing your business. “Means” in this case are tangible resources, such as the influx of new customers or increased sales of a particular product or service.
In the absence of significant cash on hand or the prospect of it coming soon, an alternative source can provide a company with an opportunity to accelerate its burn rate. This could be a strong line of credit or venture capital support. However, relying on credit or spending more on investors requires that the company make adequate forecasts of future repayments. Businesses must ensure that adequate income is coming in to support both the cash burn rate and credit obligations.
Always consider your means
Learning the formula helps you understand what your company is supposed to do. If you find that your company doesn’t really have any tangible means to accelerate its burn rate, rethink your growth plan and maintain more conservative spending—regardless of your company’s potential or the level of risk you’re willing to take.
Intangibles are something else entirely. They can be attractive to investors, but think carefully before you let them influence your calculation. Intangible assets such as team skills and experience, and workforce productivity are certainly important, but they do not have a direct relationship to the amount of cash available to a company.
Similarly, the expected growth of a particular market or industry and strong brand awareness are intangible assets. The same can be said for trade secrets, third-party evaluations, and excellent customer relationships. When you learn how to calculate a burn rate, don’t fool yourself into thinking that intangibles can be counted toward your company’s growth.
Need to update your cash flow strategy? Indiero can help you.
Your company’s survival is closely related to your burn rate and cash runway. When you’re running a growing company, your money is ultimately more important than any money you could potentially make. That’s why it’s worth learning the burn rate formula.
Want to start spending smarter today? Indinero has the answers. talk to me Now let’s see how we can help you.
