Business owners may use different tools and calculations to track the financial health of their companies. One such tool is the burn rate. This indicator shows business owners how much cash the company is spending and how quickly it’s spending it.
It’s a useful formula for new startups and companies with negative cash flow since it allows them to monitor the financial health of a business. Keep reading the article to learn about this tool and how to calculate your company’s burn rate.
What is the Burn Rate in Business?
Burn rate is an indicator that enables business owners to track how much money they are losing to determine how much longer the company can keep going without income. The estimation allows for planning on how to spend cash and generate income with the business’s resources.
There are two types of burn rates:
- gross burn rate;
- net burn rate.
The first type estimates the company’s total spending, while the net burn rate calculates net cash flow that accounts for income.
Accountants or business owners calculate the burn rate in months, but it’s not the only option. For example, the accountant can calculate a weekly or daily burn rate if a business is going through a major crisis. If a business is doing great, it’s unnecessary to keep track of a burning rate every month; quarterly or annual estimations should be sufficient.
How does Burn Rate Work?
The simplest analysis of a net burn rate shows whether the company is maintaining itself independently or not. For instance, the business isn’t self-sustaining if the burn rate is too high. However, if it’s low, the business is operating properly. The first case means the management or business owner has to adjust expenses, generate more revenue, or both.
Moreover, a business owner may compare the burn rate to the total funds to figure out how long of a runway the company has. It means that if a business owner fails to adjust the burn rate and the company runs out of cash, it will be necessary to seek alternative funds sources. In this case, the owner must apply for a loan, seek out venture capital, ask investors to fund the company, or launch an initial public offering.
Burn rate is a valuable tool not only for business owners but investors also use it. An investor analyzes the company’s business plan and compares it to the current burn rate to determine whether the plan is based on realistic expectations.
Moreover, even after investing in the company, investors may keep tracking the burn rate to see whether the business is doing well. If the company is spending more than gaining in income, investors might ask why the business is performing poorly.
Gross Burn Rate Calculation
The gross burn calculation estimates how much a business is on operating expenses alone. Here’s what you need to determine the gross burn rate:
- monthly operating expenses;
- starting capital (total cash).
A starting capital is how much someone invested in a business to run. It may include money from your pocket, loans, investors, or all these sources. Some companies state this figure in their balance sheets. Monthly operating expenses include costs a business spends to keep the business operating. For example, the list may include:
- salaries and wages;
- telephone expenses;
- traveling costs;
- office equipment and supplies;
- utility expenses;
- property tax;
- legal costs;
- bank charges;
- repair and maintenance costs;
- insurance expenses;
- advertising expenses;
- research expenses;
- entertainment expenses;
- sales costs.
The gross burn rate formula looks as follows:
Gross burn rate = (monthly operating expenses / starting capital) x 100
Suppose a company XYZ spends $13,600 in monthly operating costs. The starting capital is $120,000. Here’s the calculation:
$13,600 / $120,000 = 0,113
Multiply 0,113 by 100, and you get an 11.3% burn rate. The company XYZ spends 11.3% monthly of its starting capital. Note: this calculation relies on the assumption that the company generates a negative cash flow.
Net Burn Rate Calculation
Net burn rate calculation assumes that the business is already generating income. The formula requires the following figures:
- revenue;
- monthly operating expenses;
- starting capital.
The person calculating the net burn rate must subtract the company’s monthly operating expenses from its revenue, then divide the figure by its starting capital. The next step is to multiply the figure by 100. One may save time if they have an income or cash flow statement as these financial documents contain operating income figures.
The formula goes as follows:
Net burn rate = ((revenue – monthly operating expenses) / starting capital) x 100
Suppose a company XYZ from the previous example began earning income. The business owner still must spend $13,600 from the starting capital each month, so the business is operating, but the company made $25,000 last month.
The calculation goes as follows:
- $25,000 – $13,600 = $11,400
- $11,400 / $120,000 = 0,095
- 0,095 x 100 = 9.5%
The first figure ($11,400) shows that the company has a positive cash flow since it spends less than it earns. The burn rate of XYZ now is 9.5%.
Which Companies Should Worry about Burn Rate?
As mentioned, if a business has enough cash to cover operating expenses and generates good revenue, the accountant can make quarterly operations. However, there are a few cases when keeping track of the company’s burn rate is necessary. Here are three main examples:
- New businesses. You’ve launched an e-commerce store and have a great marketing campaign, so you assume that success is near. However, you keep burning funds until clients start buying items in your store. So, it’s important to have reasonable expectations of how long a business can operate at this rate before getting a profit.
- Existing businesses borrow money when struggling financially. Even old companies face difficulties and start running out of cash. A typical solution is to borrow money. However, the business owner must understand how long the company can operate before running out of loaned money. You also better understand how long you can test new strategies to make improvements and start earning income again.
- Startups with venture capital funding. These startups often operate at a loss for years until they succeed (gain gaining profit) or fail. It’s critical to calculate the burn rate to have realistic expectations of how long the startup can operate by burning investors’ money.
So, the burn rate is a valuable tool for different companies. It allows business owners to create plans with realistic expectations.
Final Thoughts
So, the burn rate is a convenient tool that business owners use to estimate how quickly their companies spend money. Usually, new businesses use the tool to understand how long a company can operate without profit by just burning the initial capital. However, existing businesses can also calculate the burn rate to understand whether they have a positive cash flow.
