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 easily.
In this article, we’ll take a closer look at burn rate, discuss why it’s essential, and show you exactly how to calculate this vital metric. We’ll also discuss how burn rate ties into another important metric in your business: cash runway.
Burn rate is the amount of money your business needs in a certain period—usually a month—to cover all expenses. In other words, burn rate tells you how quickly your business “burns through” capital.
Typically, burn rate calculates 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.
Investors look for low burn rates when new businesses seek startup capital because a low rate indicates the investors’ investment dollars will go further. New companies 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.
The metric is also essential for well-established businesses. The lower your business’s burn rate, the more likely your business will survive low-revenue quarters. 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 company can be profitable on paper and still fail due to a lack of cash. A low burn rate helps to 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 most straightforward burn rate calculation:
(Starting Cash – Ending Cash) / Number of Months = Monthly Burn Rate
To calculator your burn rate, you’ll need the balance sheet for the period you’re assessing and a calculator. Next, follow these four steps:
Tip: Even though burn rate is usually calculated monthly, you want to look at more than the previous month’s financial data to get a more accurate 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.
Now that you understand the process let’s apply it to an example.
Company X is reviewing the burn rate for early April, the first quarter of the year.
Company X’s cash balance on January 1, the first day of the quarter, is $160,000. Its cash balance on March 31, the last day of the quarter, is $100,000.
First, let’s subtract the ending cash balance from the beginning cash balance:
$160,000 – $100,000 = $60,000
Next, let’s divide the difference by the number of months you are assessing. In this example, that number is three:
$60,000 / 3 = $20,000
Company X’s burn rate is $20,000/month for the first quarter of the year.
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.
Your cash runway measures how long your cash will last at your current cash burn rate. The higher your cash runway—or the lower your burn rate—the more likely it is your business will survive.
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:
These are just a few examples that can affect your business’s profitability. Therefore, understanding both your burn rate and cash runway will reveal how long your business can survive with the cash you have available.
To calculate how many months your business can operate on your existing cash reserves, use this cash runway formula:
Current Cash / Monthly Burn Rate = Cash Runway
Continuing with our earlier example with Company X:
$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.
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.
Billie Anne Grigg is a contributing writer for Fundera.
Billie Anne has been a bookkeeper since before the turn of the century. She is a QuickBooks Online ProAdvisor, LivePlan Expert Advisor, FreshBooks Certified Beancounter, and a Mastery Level Certified Profit First Professional. She is also a guide for the Profit First Professionals organization.
Billie Anne started Pocket Protector Bookkeeping in 2012 to provide an excellent virtual bookkeeping and managerial accounting solution for small businesses that cannot yet justify employing a full-time, in-house bookkeeping staff.