Managing Cash Burn Starts with Accurate & Timely Data
Your company's burn rate is one of the most important metrics you can keep track of. But it’s surprisingly a metric many small businesses aren’t aware of. Burn rate isn’t a metric that’s calculated for you directly in your accounting software; but, if you leverage your financial statements, you'll have no trouble calculating it. The greatest advantage of understanding your burn rate is in knowing how this impacts your runway. Runway is the amount of time the business can continue to operate before shutting down or raising more capital. In this post, we'll take a more in-depth look at burn rate, explore why it's important, and show you exactly how to calculate this important metric. We'll also explain the relationship between your business's burn rate and how it affects VC funding.
Your company's burn rate is one of the most important metrics you can keep track of. But it’s surprisingly a metric many small businesses aren’t aware of. Burn rate isn’t a metric that’s calculated for you directly in your accounting software; but, if you leverage your financial statements, you'll have no trouble calculating it. The greatest advantage of understanding your burn rate is in knowing how this impacts your runway. Runway is the amount of time the business can continue to operate before shutting down or raising more capital.
In this post, we'll take a more in-depth look at burn rate, explore why it's important, and show you exactly how to calculate this important metric. We'll also explain the relationship between your business's burn rate and how it affects VC funding.
What is Burn Rate?
Burn rate is used to describe how fast a new company spends its capital on overhead costs before it starts making money from operations. It’s a way to measure the cash flow that goes down.
Most of the time, the burn rate is given in terms of how much cash is spent each month. For example, if a company's burn rate is $1 million, it means that the company spends $1 million every month.When calculating the burn rate it is important to determine if it is your gross burn rate or your net burn rate. This example is considering your gross burn rate.
Explaining Gross Burn Rate
Operational costs are tallied up as the Gross Burn Rate for a business. On a monthly basis, it is computed by adding up all of the company's operating expenses including rent and salary. Regardless of revenue, it gives more information on a company's cost drivers and efficiency.
Explaining Net Burn Rate
A company's Net Burn Rate is the amount of money it's really losing. It is computed by deducting its revenue from its operational expenses. It's also done on a monthly basis to keep track of trends. It illustrates how much money a business requires to keep going for a while. However, there is one thing that needs to be taken care of: revenue fluctuation. In the absence of any change in costs, a decrease in revenue might lead to a higher rate of burn.
How to Calculate Burn Rate
Burn rate can be calculated using the formula below:
- (Starting Cash - Ending Cash) / Number of Months = Monthly Burn Rate
Example burn rate calculation for a startup
For this simple calculation, use the following assumptions.
- A start-up currently has $200,000 in its bank account
- The total cash expenses each month are $20,000
- At the end of each month, the net change in cash for the month is $20,000
By dividing the $200,000 in cash by the $20,000 burn, the implied runway is 10 months. Within 10 months, the start-up must raise additional funding or become profitable, as the assumption here is that the monthly performance remains constant.
Note, that there were no cash inflows in the example above – meaning, this is a pre-revenue start-up with a net burn that is equivalent to the gross burn.
If we assume that the start-up has monthly free cash flows (FCFs) of $5,000, then:
- The $5,000 in cash sales is added to the $20,000 in total cash expenses
- The net change in cash per month is cut in half to $15,000
- Upon dividing the $200,000 in cash by the $15,000 net burn, the implied runway is 16 months
In the 2nd scenario, the company has a 66% increase in cash runway because of the $5,000 in cash inflows coming in each month.
Why venture capitalists want to know your burn rate
When startups seek funding, investors want low burn rates since a low rate signals that the investors' investment dollars will go further if they choose to invest in the business. New businesses that have a low rate of capital expenditure are more likely to grow and become successful, which will result in a return on any investments that were made in the company.
These ideas are very important to venture capitalists because almost all early-stage companies fail after they spend all their money (and existing and new investors are not willing to contribute more).
Also, no investment firm wants to be the one that tries to "catch a falling knife" by putting money into a high-risk start-up that will quickly use up the money from the investment and then quit.
By knowing how much money the start-up needs to spend and how much money it has on hand, the financing needs can be better understood, which helps the investor make better decisions (s).
A key difference is that the metric should only count actual cash inflows and outflows and not include any non-cash add-backs. This is a measurement of "real" cash flow. So, the estimate of the startup runway is more accurate in terms of how much cash it really needs.
All of this means that keeping track of the monthly cash burn benefits startups by giving them information about:
- Current spending needs to make plans for its next round of funding in advance
- The costs of running a business (and the amount of money that needs to be brought in to start making a profit, or the "break-even point")
- How many months can the current level of spending be kept up before more money is needed?
- Or, for companies in the seed stage, how long the company has to work on product development and tests.
- Being able to compare how well money is spent and how that affects output
How to Reduce Burn Rate
Reducing your burn rate means making some tough decisions. Here are some of the ways you can reduce your burn rate.
Accurate and on-time financial data
We can’t stress enough how important it is to have accurate and timely financial data. Any incorrect information could lead to you making the wrong decision when it comes to managing your burn rate. Relying on spreadsheets or accounting software that only updates once a day could lead to your business making the wrong financial decisions.
For all you know, your business could be healthy, but if your financials show you’re losing money, you might end up making a decision that could harm your business in the long run.
Layoffs and pay cuts
Businesses with high labor costs may find significant savings by postponing new hiring initiatives, letting go of non-essential employees, or reducing perks. Keep in mind, however, that any reduction must be smart and sustainable.
Increase your revenue
Look for ways to increase your conversion or close rates, your prices, the number of prospects that enter your pipeline, and the amount of traffic that comes to your website. If there are more sales, there should be more dollars coming in as a result.
Reduce your direct costs
Finding ways to eliminate needless inventories of raw materials and other direct costs can make a major impact on cash flow for organizations with poor profit margins if the right strategies are implemented.
Take a close look at your budget. Are there expenses that aren’t contributing to your company’s success?
Ditch unprofitable revenue streams
Take a close look at your revenue streams. If you find one or two that don't make money, you don't have to keep them. Put them on hold until you figure out how to make them work, or get rid of them and focus on more profitable streams of income.
Bill sooner and collect faster
Although this does not directly impact your burn rate it does ensure you have more cash sooner. As a startup or small business, every customer matters. Sometimes, you’re willing to let customers hold off on paying you because you want to be seen as the “good guy” and don’t want to hound your customers about paying you.
Unfortunately, this can blow up in your face. By letting your customers go beyond the payment terms in their invoices, you can mess up your financials, cash flow, and forecasting. Your goal should be to get paid as quickly as possible to keep your cash burn healthy.
Consider refinancing debts
Not only are your own expenses a factor in determining your financial runway but so are your expenses. It's possible that refinancing your debt could assist increase your cash runway if your monthly debt payments are significant. It's in your best interest to refinance your debt before you are forced to do so; don't put it off until you are already facing a problem with your cash flow.
How Decimal helps manage cash burn
Decimal provides accounting operations for small businesses: bookkeeping, technology setup/support, bill pay, payroll, and more. Think of Decimal as your back office on autopilot.
Here’s why you should work with Decimal:
- Dedicated accounting team: Led by a cloud accounting specialist, and supported by technology experts, we're designed to support all of your back office needs
- Automated back office: Decimal leverages technology to simplify your back office and eliminate work for you. It's not just bookkeeping: we'll take care of bill pay, payroll, invoicing, and more.
- Fixed pricing with no hidden fees: Work with your Decimal team without the worry of extra billable hours. You'll never be charged more than a fixed price, allowing us to work together to best streamline your financial operations.
Contact us to learn how Decimal can help your business.