For any startup aiming to grow, understanding your burn rate is essential. This guide will help you grasp how to calculate and manage your burn rate, helping prevent your startup from running out of money too soon.
Here’s what we’ll go through
- Burn Rate Basics
- Preparation for Calculating Burn Rate
- Calculating Gross Burn Rate
- Calculating Net Burn Rate
- Analyzing Burn Rate Results
- Strategies for Managing High Burn Rate
- Using Burn Rate for Strategic Decisions
Keeping an eye on your burn rate means you’re making smart choices to keep your startup thriving. Let’s get into how to calculate your burn rate and use it to maintain your startup’s financial health.
This guide is also related to our articles on understanding and calculating ebitda, cash vs. accrual accounting, and understanding gross vs. net profit.
Burn Rate Basics
Burn rate is crucial in the startup world. It shows how fast your startup is spending its cash before making money. Understanding it helps you see your startup’s financial health and how long you can last before needing more cash. There are two types: gross burn rate and net burn rate.
Gross Burn Rate is your monthly cash spent on all expenses, like salaries and rent. It shows the basic cost to run your business.
Net Burn Rate takes into account your revenue, subtracting it from your gross burn rate. This tells you how fast your cash is really running out after making some money.
Knowing both burn rates helps startups plan finances, decide when to cut costs, or when to look for more money. It’s also vital for investors to check a startup’s financial health and how long it can last with its current cash.
Preparation for Calculating Burn Rate
Before you figure out your burn rate, you need two important financial reports: your cash flow statement and income statement.
Cash Flow Statement: This report shows all the cash coming in and going out of your business. Focus on the operations part because it tells you about the cash from doing business and the money spent on things like supplies and operations, which you need to know for your burn rate.
To make a cash flow statement, collect all your cash transaction records, like sales, expenses, and bank statements. Make sure you properly list where each piece of cash came from or went to.
Income Statement: This is about your business’s income, costs, and profits. It helps you see how your sales turn into net income or loss, showing how well your business is doing. For burn rate, look at the cash parts of this statement, mainly the money from sales and the operating costs.
To prepare this, keep track of all money made and spent. Focus on operating costs since they affect your daily cash flow the most.
Calculating Gross Burn Rate
Calculating your small business’s gross burn rate is straightforward and provides critical insight into how fast your company is spending its cash reserves without accounting for any incoming cash flows.
Here’s a step-by-step guide to help you calculate the gross burn rate, followed by an example to illustrate the process.
Collect Your Financial Info: First, get your cash flow statement and income statement for the time you’re looking at. Make sure these are current and include all cash activities.
Find Your Total Cash Spending: Look at your cash flow statement to see all the money you spent during this time. Count things like rent, salaries, and utility bills – any money that left your business for day-to-day operations. Don’t include money spent on investments or loans since we’re only looking at what you spent to run your business.
Pick Your Time Frame: Choose how long you want to measure your burn rate for. Most people do it by month, but you can pick a different timeframe that matches how your business uses cash.
Do the Math for Gross Burn Rate: Take your total spending and divide it by the number of months (or whatever period you chose). This tells you your average cash spending per month, showing how much money your business uses up monthly
Example Calculation
Let’s consider a hypothetical startup for a clearer understanding:
Time Period: January 1 to March 31 (3 months)
Total Cash Outflows: The startup spent $90,000 over these three months. This includes:
- Rent: $15,000
- Salaries: $45,000
- Utility Bills: $5,000
- Marketing: $15,000
- Contractors: $10,000
Given this information, we calculate the gross burn rate as follows:
- Total Cash Outflows: $90,000
- Time Period: 3 months
Gross Burn Rate = $90,000 / 3
Gross Burn Rate = $30,000 per month
This means the example startup spends about $30,000 a month. Knowing your gross burn rate is key because it shows how fast you’re going through your cash just from regular business costs, not counting any money you make or extra funding.
Calculating Net Burn Rate
Net burn rate adds in the money you make to the equation, unlike gross burn rate, which only looks at spending. It shows how cash levels change over time, factoring in income. This gives a real view of how fast you’re using cash and how long it’ll last with your current earnings and costs.
Calculating Net Burn Rate: Steps and Example
- Find Cash Spent and Earned: Use your cash flow statement to see how much money you’ve spent (outflows) and earned (inflows) from things like sales.
- Work Out Net Cash Flow: Subtract the money earned from the money spent. This number can be negative (if you’re spending more) or positive (if you’re earning more).
- Pick a Time Frame: Usually, you do this monthly, but pick what works for you.
- Calculate Net Burn Rate: Divide your net cash flow by the months in your chosen period to see your monthly cash burn after income.
Practical Example
Let’s consider the same hypothetical startup from the previous example but add revenue into the equation:
- Time Period: January 1 to March 31 (3 months)
- Total Cash Outflows: $90,000 (same as before)
- Total Cash Inflows (Revenue): $45,000
Given this new information, let’s calculate the net burn rate:
- Net Cash Flow: $90,000 (outflows) – $45,000 (inflows) = $45,000 net outflow
- Time Period: 3 months
Net Burn Rate = Net Cash Flow / Time Period
Net Burn Rate = $45,000 / 3
Net Burn Rate = $15,000 per month
After counting the money made, the startup’s net burn rate drops to $15,000 a month, half of the $30,000 gross burn rate. This shows the startup can make money to cover some costs, making its cash last longer.
Analyzing Burn Rate Results
Understanding your “runway” is key—it’s how long your business can keep going with its current cash. Divide your cash on hand by your net burn rate to find this. A longer runway is good; it means you have more time to make your business profitable or find more money. A short runway means you need to act fast to cut costs or up your income.
What Is a Good Burn Rate?
Good Burn Rate: It’s good if it fits with your plans and goals. You’re in a strong position if your burn rate and cash let you hit your next big targets, like growing your user base or getting more funding.
Bad Burn Rate: It’s a problem if it’s eating up your cash too quickly, risking your ability to meet important goals. You’ll need to quickly find ways to spend less or bring in more money.
Runway Check: If your net burn rate shows only six months of cash left, but you need nine months to hit your next big goal, you either cut costs or find more money.
Funding Needs: A high burn rate might mean you’ll need more funding soon. Knowing your burn rate helps plan for fundraising and talk to investors about your business’s financial shape and their risk.
Making Changes: Your burn rate can lead to changes in how you do things. You might need to spend less, change how you make money, or adjust your plans to keep your business going longer.
In short, knowing your burn rate helps you make smart moves to keep your business alive and kicking. It guides you in balancing growth, spending, and making sure you can reach your goals.
Managing High Burn Rate
When your burn rate analysis reveals a higher than sustainable level, taking decisive action to manage and mitigate this risk becomes crucial. Here are strategies for managing a high burn rate, focusing on reducing expenses, boosting revenue, and considering funding options or strategic adjustments.
Reducing Expenses to Extend Runway
- Prioritize Saving: Cut or lower costs that don’t directly help your business grow or are essential to running it.
- Negotiate with Vendors: Talk to suppliers for better deals or more time to pay.
- Optimize Operations: Make your business run smoother by cutting waste and using tech to automate tasks.
- Employee Costs: Try to avoid layoffs by freezing hires or asking staff to work part-time.
Boosting Revenue Growth
- Focus on What Works: Put your energy into the products or services that make the most money.
- Up Your Marketing Game: Target your best customers more sharply to increase sales.
- Find New Money Makers: Look for new ways to make money that fit with what you already do well.
Seeking More Money or Changing Tactics
- Look for Funding: If you can’t cut costs or up sales enough, look for new investment or loans.
- Partner Up: Joining forces with another business can open new opportunities without a big investment.
- Rethink Your Plan: If things aren’t working, be ready to change your approach or focus on a different market.
- Keep Everyone In the Loop: Be open with your team and backers about what you’re doing to fix the burn rate issue.
Cutting costs, finding ways to make more money, looking for new funding, or even changing your business direction are ways to manage a high burn rate. These steps can help keep your business going and set you up for future success.
Forecasting and Scenario Analysis
Financial Forecasting: Combine your burn rate with future cash flow, revenue, and expense predictions. This helps you see when you might run low on cash and need to act.
Scenario Analysis: Look at different what-if scenarios, like the best, worst, and most likely cases. Think about market changes or new challenges and how they impact your burn rate.
Contingency Planning: Make backup plans for different scenarios. If something could raise your burn rate, figure out now how you’d handle it, whether by cutting costs or finding more money.
Strategic Decisions: Use what you learn from your burn rate and scenarios to make smart choices. For instance, if entering a new market might lower your burn rate and give you more time, it could be a good move. But, if growing too fast might make your burn rate too high, it’s better to steady your current business first.
Keeping an Eye on Your Burn Rate
Always watch your burn rate and update your plans as things change in the real world and the market. Staying on top of it lets you quickly adjust your strategy when you spot chances or run into problems.
In short, your burn rate is more than a cash tracker. It’s key for smart planning and making big decisions. With regular burn rate checks and updates to your forecasts, you can guide your business through ups and downs, grab new opportunities, and aim for steady growth and financial health.
Conclusion
Getting a handle on your burn rate is crucial for startups that want to last and succeed. We’ve talked about why it’s critical to keep an eye on these burn rate numbers to gauge your business’s health and plan for the future.
Using burn rate in your planning means thinking ahead and preparing for different outcomes. This helps you make choices that keep your business stable and growing. Always keep track of your burn rate to steer clear of money problems and navigate the ups and downs of growing your business.
Next, check out our guides on 14 common accounting errors and how to avoid them, bookkeeping 101: a guide to bookkeeping basics, and how to do bank reconciliations.
FAQ: Calculating Burn Rate
Here's some answers to commonly asked questions about calculating your burn rate.
What is burn rate and why is it important?
Burn rate shows how quickly a startup uses its cash. Gross burn rate counts all spending, while net burn rate also considers earnings. It’s crucial because it tells startups how long they can operate before needing more money, guiding them in financial planning and ensuring they don’t run out of cash.
How do you calculate gross and net burn rate?
To calculate the gross burn rate, add up all your expenses over a certain period, typically a month, then divide by the number of months to get your average monthly spend. This measures your monthly cash outflow without income.
For net burn rate, first find your gross burn rate, then subtract your total income for the same period. Divide this number by the number of months to see how much cash you’re really losing each month, after considering any revenue. This gives you a clearer picture of your financial situation by including your earnings.
What should a startup do with a high burn rate?
If your burn rate is too high, quickly reduce costs and increase income. Prioritize essential spending, negotiate with vendors, focus on profitable products, and explore new revenue avenues. If necessary, seek more funding. Always adjust based on burn rate monitoring to avoid running out of cash.
