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Burn rate is one of the most important metrics you can know for your business. Unfortunately, many small business owners don’t understand what burn rate is or how to calculate it. Burn rate isn’t a metric your accounting software will calculate for you directly, but by using your financial statements, you can calculate it very easily.
In this article, we’ll take a closer look at burn rate, discuss why it’s important, and show you exactly how to calculate this vital metric. We’ll also discuss how burn rate ties in to another important metric in your business: runway.
You’ve heard the idiom, “Money burns a hole in my pocket.” Although this expression has no etymological relationship to burn rate, it might help you understand what burn rate is.
Burn rate is the amount of money your business needs in a certain period of time—usually a month—to cover all expenses. In other words, burn rate tells you how quickly your business “burns through” cash.
Typically, burn rate is used to calculate how quickly a company will go through its startup capital before becoming cash flow positive. However, all businesses—regardless of their stage in the business life cycle—can benefit from knowing their burn rates.
Burn rate is especially important for new businesses seeking startup capital. Investors look for a low burn rate in new businesses, because a low rate indicates the investors’ investment dollars will go further. New businesses with a low burn rate are more likely to gain traction and become profitable, thus yielding a return on any investments made in the business.
But the metric is important for well-established businesses, too. The lower your business’s burn rate, the more likely your business will be to survive a downturn in revenues. A low burn rate is an indicator of a strong cash position, and a strong cash position is a vital indicator of a business’s health. A business can be profitable on paper and still fail due to a lack of cash. Having a low burn rate helps ensure this doesn’t happen to your business.
There are several different ways to calculate burn rate, some more complicated than others. All methods tell you how quickly your business is using up its cash reserves, so let’s look at the easiest burn rate calculation:
(Starting Cash – Ending Cash) / Number of Months = Monthly Burn Rate
Start by defining the time period you will be assessing. Burn rate is a current metric, meaning you want to look at a recent time period.
Even though burn rate is usually calculated monthly, you want to look at more than the previous month’s financial data to get a good calculation. This will help you capture expenses and other outlays of cash that don’t occur monthly. It will also help make sure your calculations aren’t skewed by an extraordinarily good (or bad) sales month. So, for the purposes of this example, let’s look at the last quarter, or three-month period.
Now that you’ve defined the period you are assessing, you will find the starting cash and ending cash balances for that period. To keep things easy, let’s say you are doing this exercise in early April, meaning you are assessing the first quarter of the year. Determine your cash balance on January 1 by reviewing your balance sheet. You want to use the cash balance on your balance sheet rather than using your bank statement, because your balance sheet will include any uncleared checks or deposits. Make a note of this number—let’s say it’s $160,000.
Now, determine your cash balance on March 31, the last day of the quarter. Again, you will get this number from your balance sheet. Make a note of this number as well—let’s say it’s $100,000.
Next, you will subtract your ending cash balance from your beginning cash balance:
$160,000 – $100,000 = $60,000
Finally, you will divide the difference by the number of months you are assessing. In this example, that number is 3:
$60,000 / 3 = $20,000
This means your business’s burn rate is $20,000/month.
Potential investors might prefer to use a different gross burn rate or net burn rate calculation, which only takes into account operating expenses. For the purposes of managing your small business, though, the calculation presented above will give you the information you need to help you manage your cash flow. It takes into account not only your operating expenses, but also other cash outlays such as loan payments and owner’s draws.
Most small business owners don’t like to think about a scenario where their business might run out of cash, but this is a real possibility. Several things can cause your business to run out of cash: a downturn in sales, an upswing in expenses to promote growth without enough capital to back those expenses, and slow collections are just a few examples of this. It’s important to know exactly how long your business can survive on the cash you have on hand.
This is where your cash runway comes into play. Your business’s cash runway tells you how many months you can operate on your existing cash reserves. The cash runway calculation is:
Current Cash / Monthly Burn Rate = Cash Runway
Continuing with our example above:
$100,000 (ending cash for the 3-month period) / $20,000 (burn rate) = 5 (runway)
If all things remain equal in our example business—meaning if sales or collections don’t decrease and expenses or other cash outputs don’t increase—this business has enough cash to sustain it for five months.
The higher your cash runway—or the lower your burn rate—the more likely it is your business will survive. There are several simple ways to decrease your business’s burn rate and improve your cash runway:
Calculating the burn rate in your business isn’t difficult. Although it can be uncomfortable to face the reality of a high burn rate (and a short cash runway), it is much better to know these metrics in your business and address them before they become a problem.
Any number of factors—many of them outside of your control—can lead to an unexpected downturn in revenue and cash flow in your business. When you address your burn rate and cash runway proactively, while things are going well in your business, you will be better able to weather any storms your business encounters.