How to Understand your Burn Rate
The term burn rate is used to describe how fast a company is spending its cash reserves to fund overheads. It is also a measure of negative cash flow, and it’s usually quoted as cash spent per month.
For example, if your company has a cash reserve of $250,000 with a burn rate of $50,000 per month, your company will run out of cash in five months. In other words, a burn rate is the rate of depletion of a company’s cash pool.
This is a common metric of performance and valuation for businesses of any size but especially for start-up companies. In its early stages, a start-up is often unable to generate a positive net income as it is focused on growing its customer base and improving its products or services. This is why venture capitalists often provide funding based on a company’s burn rate.
How to Calculate Burn Rate
This KPI can be broken down into two categories: gross burn rate and net burn rate.
Gross Burn Rate
Gross burn rate refers to a company’s operating expenses and can be calculated by adding all operating expenses such as; rent, salaries, and other overhead expenses. Gross burn rate is often measured on a monthly basis and provides insight into a company’s cost drivers and efficiency regardless of how much money is coming in.
Net Burn Rate
Net Burn Rate refers to the rate at which a company is losing money and is calculated by subtracting its operating expenses from its revenue. It shows how much cash a company needs to continue operating for a period of time and is also measured on a monthly basis.
Why Ignoring This KPI Is Not An Option
82% of startups fail because of cash flow problems. This tells us just how important understanding your burn rate is. Understanding this metric is the key to recognizing where you can improve within your company and how to plan for the future. Especially if you’re a funded startup, this is something you simply just can’t ignore.
It Identifies Necessary Budget Cuts
Your burn rate can signal where you’re overspending. If you’re running a startup, chances are you’re overspending somewhere. Take a look at the following areas within your company as there are often culprits for overspending.
- Branding: Branding is often a point of overspending for new startup companies as the process involved in creating unique and eye-catching branding is time-consuming and extremely expensive.
- Vendor Relationships: The world of supply chain management can be overwhelming for startups, full of trial and error that often results in burning through more cash.
- Office Space: Luxurious office space proves to be very tempting for young startup companies and they often find themselves dealing with lengthy, expensive leases and slower-than-expected staff growth issues
Issues like those listed above are a great example of why calculating and staying on top of your company’s burn rate is so important. Assuming you spot it fast enough, a high burn rate due to factors like these can be an easy fix, and start you down a more cost-effective path. Oftentimes a young company can’t afford the luxury of hiring an experienced designer for their branding and other options will need to be considered. The same goes for the gorgeous corner office, you might just not be there yet. And bad rates from vendors are an opportunity to start shopping around.
Another issue often seen with young companies is they forget about their startup debt. It’s vital to understand the fine print of any debt you have taken on. You may be found in default or negligent if you run the company into the red.
Don’t Get Burned By The Burn Rate
A high burn rate is an indicator that a company is burning through its cash supply faster than its bringing in money which is a recipe for financial disaster. This could cause investors to start implementing more aggressive timetables to realize revenue. Alternatively, it may mean that investors would have to put more money into a company to give it more time to generate revenue and become profitable. Regardless, a high burn rate is something that needs to be remedied.
How To Reduce Your Cash Burn Rate
This rate is intimately tied to almost all spending within your business. Surprisingly, overspending doesn’t always look like large luxurious purchases, it can be subtle and hardly recognizable until you really dig into your finances. In the case that your burn rate is high, there are several methods that a startup can make use of to minimize its high burn rate and avoid running out of capital. Here are a few to consider:
- Evaluate your budget and start making cuts on unnecessary spending
- Cut back on the number of employees or start reducing salaries
- Consider sending bills out to your customers sooner
- Ask suppliers for payment plans or extensions
- Hold off on large expenditure items
- Look into refinancing your debt to get more favorable terms
- Shop around for more affordable vendors
- Sell excess inventory to generate more sales
- Drive more sales through specific marketing campaigns
- Consider raising prices on your products or services
- Reduce churn rate
- Cut off products that don’t sell
- Focus on growing your customer base
Analyzing, understanding, and improving your cash burn rate can be an overwhelming task, especially if it’s something you’re unfamiliar with, but it’s necessary when your startup is facing tough challenges. Startups often need to be creative when it comes to reducing expenses and increasing income.
While it sounds great to be the company that has gourmet coffee in the breakroom for your employees to enjoy, it’s not always practical or realistic in the beginning. You can be successful and ensure sustainable growth if you work on your strategy and understand how you’re spending money.