What is Burn Rate?
Burn rate refers to the speed at which the company spends its cash reserves to cover operating expenses. Imagine your business’s cash as a bucket of water, and the burn rate is the speed at which it’s leaking out. Typically, burn rate is a crucial metric for startup companies or companies without profits and revenue. This metric indicates the health of the business and how long it can sustain operations before necessitating funding.
Why is burn rate important?
Reflecting the financial health of a business, here are reasons why burn rate matters:
- Indicates financial stability: Acting as a financial health check, burn rate helps businesses monitor how quickly they are depleting their cash reserves — showing whether the company is at risk of running out of funds.
- Determines runway: Runway refers to the time a company has before its cash reserves are fully exhausted. Burn rate informs companies, especially startups, on planning, budgeting, and scaling.
- Guides decision-making: Understanding burn rate allows companies to make informed decisions about financial expenditures. For instance, a high burn rate may necessitate cost-cutting, whereas a low burn rate may encourage growth initiatives.
- Helps in crisis management: During economic crises or unexpected turndowns, understanding burn rate enables companies to quickly reduce costs, adjust strategies, and secure additional funding.
- Helps balance growth and sustainability: Balancing rapid growth with manageable expenses is critical for businesses, especially startups. Burn rate guides businesses in ensuring that growth efforts don’t compromise long-term financial sustainability.
How to Calculate Burn Rate
To calculate the burn rate, you’ll need:
- Starting Cash Balance: The amount of cash your business had at the start of the period
- Ending Cash Balance: The amount of cash remaining at the end of the period.
- Time Period: The duration over which the burn rate is calculated, typically in months.
The basic formula for burn rate is:
Burn Rate = (Starting Cash – Ending Cash) ÷ Number of Months in the Period
There are two types of burn rate: Gross Burn Rate and Net Burn Rate. Gross Burn Rate measures the total cash outflows in a month, without revenue or income. Net Burn Rate accounts for cash inflows and how much cash is lost monthly.
Here’s an example of burn rate calculation:
- Starting Cash: $200,000
- Ending Cash: $140,000
- Time Period: 2 months
Burn Rate = (200,000 – 140,000) / 2 = $30,000 per month
If the same business generated $20,000 in revenue during each month:
Net Burn Rate = 30,000 – 20,000 = $10,000 per month
What is a good burn rate?
A good burn rate isn’t a fixed number — it’s a dynamic metric that depends on a business’s goals, situation, and strategy. Some indicators of a good burn rate are: being aligned with business goals, having enough runway, being predictable and monitored, and being balanced between risk and reward.
Though there is no universal number, different industries have benchmarks:
- Tech Startups: Typically higher burn rates, due to significant costs like R&D
- Retail or Service-based: Lower burn rates since they tend to generate revenue earlier
- Nonprofits: Often have low burn rates to extend funding
How to Manage Burn Rate
- Reduce fixed costs: Fixed costs like rent and utilities can add up. Consider renegotiating leases, eliminating non-essential subscriptions, or switching to more affordable service providers.
- Streamline operations: Evaluate current processes to eliminate redundancies and bottlenecks. Invest also in automation tools to handle repetitive tasks instead of adding resources.
- Plan for contingencies: It’s always better to have a backup plan. Build an emergency fund from a portion of your cash reserves to handle unplanned expenses.
- Optimize sales: To avoid significant sales costs, double down on offerings that generate the highest revenue. Focus also on upselling and cross-selling to improve revenue.
- Explore new revenue streams: Look for additional revenue streams, such as offering complementary products, building partnerships, or entering new markets.