Burn rate is a term used mostly by venture capitalists to gauge the performance of their investments. Venture capitalists want to know how businesses use their money, when businesses might need additional funding and when the businesses they’re funding could start turning a profit.
Let’s look at how to calculate burn rate and how you can use the numbers to manage your business.
What Is Burn Rate?
The burn rate definition used by venture capitalists is the measurement of how quickly a company is spending its capital to pay its operating expenses, such as rent, salaries, product development and marketing. Burn rate is usually expressed in terms of money spent per month.
In effect, burn rate is a measure of negative cash flow. New businesses typically operate at a loss until they produce enough revenue to generate positive cash flow. The burn rate shows how much cash the fledgling business needs each month to stay in business, and it can indicate when a business will require additional funding.
Operating expenses are either fixed or variable. You should know how your variable expenses factor into your burn rate so that you can shed these expenses if the market takes a sudden downturn and you need to conserve cash.
Why Is Burn Rate Important?
Business owners must know how much cash they’ll need each month to operate. By knowing your burn rate and comparing it to how much cash you have in the bank, you’ll be able to figure out how long you can stay in business before you run out of money.
Monitoring your burn rate and looking ahead gives you better control over your company’s destiny. You can be proactive instead of reactive. If it looks as though you might run out of cash in a few months, you can raise funds or cut your spending. Trying to raise money at the last minute limits your options and puts you in a terrible negotiating position.
How to Calculate Burn Rate
To find your burn rate, subtract your ending balance from your starting balance, then divide that difference by the time period between your starting balance and ending balance.
Burn Rate = (Starting Cash on Hand − Ending Cash on Hand) ÷ Months
To get a reliable figure, calculate your burn rate over several months to find an average instead of looking at a single month.
Here’s how you’d calculate the burn rate over a quarter, or three months:
Monthly Burn Rate = (Cash on Hand at Beginning of Quarter − Cash on Hand at End of Quarter) ÷ 3 Months
Let’s suppose you had $450,000 in the bank at the beginning of the quarter and $300,000 at the end of it. In this scenario, your monthly burn rate is $50,000 per month.
Monthly Burn Rate = ($450,000 − $300,000) ÷ 3 = $50,000 per month
How to Use Your Burn Rate
Monitoring your burn rate will alert you to any sudden changes in your cash outflow that might affect your ability to stay in business.
Once you know your burn rate, you can calculate your runway, or how many months you have before you run out of cash. To calculate your runway, divide how much cash you have by your monthly burn rate.
Runway = Cash on Hand ÷ Monthly Burn Rate
Let’s go back to our example. Your company had $300,000 in the bank at the end of the quarter, and your average burn rate is $50,000 per month. Therefore, you’d have six months of runway.
Runway = $300,000 ÷ $50,000 per month = 6 months
At this point, you’d need to either raise funding, reduce spending or begin generating enough revenues to stay in business.
What Financial Options Are Available?
The burn rate definition is a key metric for new businesses, but it can be a critical indicator for established businesses, too. A company with a high burn rate and a negative cash flow might not be able to obtain a traditional loan from a bank.
Lenders are not fond of lending money to businesses that aren’t making a profit. But businesses that aren’t generating a profit can still seek money from investors or look to alternative lending sources.