We’ve all heard the ominous phrase ‘burning through your cash’ – nobody want that! But what does the term ‘burn rate’ mean exactly, and is it as bad as it sounds? Let’s learn more.
In business, burn rate represents the rate of negative cash flow and reflects how quickly a company is spending its funds to sustain its operations, including expenses like salaries, rent, utilities, marketing, and other overhead costs. Knowing your burn rate is crucial for managing your finances effectively, planning for the future, and keeping that cash flow healthy.
Why is Burn Rate Important?
Burn rate is a vital component that will guide how you spend, how you forecast, when you start looking for investors, and how you make strategic decisions for your business. It is an important metric for the following:
1. Financial Management
Knowing your burn rate helps you keep track of your expenses and manage your cash flow effectively. This can help you make better decisions about budgeting, spending, and prioritizing expenses.
2. Planning and Forecasting
By understanding your burn rate, you can forecast how much cash might be needed and plan accordingly. This can help you avoid surprises and ensure that you have enough cash on hand to sustain your business during slower times.
Investors often look at a company’s burn rate to assess its financial health and growth potential. If a company has a high burn rate, it may be an indicator that it needs more funding to sustain its operations and grow, making it a less enticing prospect.
4. Cost Reduction
High burn rates mean that a company is spending too much money on unnecessary expenses. By identifying these areas of high output, you can cut costs and reduce burn rate, which can lead to improved profitability.
How to Calculate Burn Rate
Buckle up, this might get complicated! To calculate burn rate, you need to add up all of your monthly expenses and divide that by the amount of cash reserves you have. For example, if your monthly expenses are $50,000 and you have $500,000 in cash reserves, your burn rate is $50,000/$500,000, or 10%. This means you are spending 10% of your cash reserves every month.
Gross burn rate refers to the total amount of cash that a company is spending on its operating expenses per month, before taking into account any revenue generated during that period. This metric is useful for measuring the total amount of cash a company is using to maintain its operations, without factoring in any external sources of funding or revenue.
As an example, let’s look at the following expense scenario:
- Salaries: $50,000
- Rent: $10,000
- Utilities: $2,000
- Marketing: $5,000
- Other overhead costs: $8,000
To calculate the gross burn rate, you would add up all these expenses:
$50,000 (salaries) + $10,000 (rent) + $2,000 (utilities) + $5,000 (marketing) + $8,000 (other overhead costs) = $75,000
So the company has a gross burn rate of $75,000 per month. This means that the company is spending a total of $75,000 each month to maintain its operations, before taking into account any revenue it may be generating during that period.
Net burn rate is equal to total costs minus revenue. It’s usually divided into all the operating expenses mentioned above, plus whatever income your startup brings in. Compared to gross burn rate, net burn rate gives you a more detailed picture of your business.
Let’s say a startup company has the following financial information:
- Beginning of the month cash balance: $100,000
- End of the month cash balance: $80,000
- Monthly revenue: $20,000
- Monthly expenses: $50,000
To calculate the net burn rate, you would subtract the monthly revenue from the monthly expenses and then divide the result by the number of months in the given period. In this case, the period is one month.
So, the calculation would be as follows:
Monthly cash burn = Monthly expenses – Monthly revenue Monthly cash burn = $50,000 – $20,000 Monthly cash burn = $30,000
Net burn rate = Monthly cash burn / Number of months in the period Net burn rate = $30,000 / 1 Net burn rate = $30,000
Therefore, the net burn rate for this company is $30,000 per month. This means that the company is losing $30,000 in cash each month after accounting for its monthly revenue. Not a pretty picture.
It’s important to note that burn rate is not the same as cash flow. Cash flow is a measure of the inflows and outflows of cash in a business, while burn rate is a measure of how quickly a company is using up its cash reserves and might be a better measurement of your financial standing.
Managing Burn Rate
Consistently managing your burn rates is not only good for the bottom line, but can help focus your attention on areas that need a rethink (unnecessary expenses, or ineffective products). If your company isn’t ‘feeling the burn’, you’re heading in the right direction!
Here are five strategies to help you manage your burn rate effectively:
- Make more money: The best way to manage burn rate is to generate revenue. If you can bring in more money than you are spending, you can extend your runway and give yourself more time to scale your business. Focus on generating revenue early on and keep your expenses as low as possible.
- Cut unnecessary expenses: Look for ways to cut unnecessary expenses and reduce your burn rate. This might mean cutting back on marketing expenses, reducing salaries, or outsourcing certain specialist services.
- Raise additional funds: If your burn rate is too high, you may need to raise additional funds to extend your runway. This could mean raising money from investors, taking out a loan, or crowdfunding.
- Plan for the long-term: When managing your burn rate, it’s important to plan for the long term. Don’t make short-term decisions that could hurt your business, rather focus on building a sustainable business that can continue to grow over time.
Getting in the OCFO Experts to help you manage your cash and curtail burn rate
Your growing business is going to consume your cash reserves – you can count on that. As you grow, there will be a bigger and bigger ask of your available resources, and your burn rate will increase while managing all aspects of your operation becomes ever more complex. As an entrepreneur, your job is to focus on growing the company, while a dedicated Outsourced CFO gives you the clarity to make the right financial calls as you power toward the next milestones. For instance, periods of high profitability and liquidity events (fundraises, exits) can lead to excess money in the bank. Make smart cash allocations and manage your cash flow and burn rate with ease, led by the insight and experience of a CFO who has handled large sums before.
Contact OCFO, we have the experts and the tools to help you manage your financial situation and keep an eye on that burn rate and plan for future liquidity.