Burn rate, a survival metric - how does it work?
While a company is in its infancy, capital is crucial to its survival. But having financial resources is different from being financially savvy. CNBC reports that 44% of startups fail because they run out of money due to poor financial planning. This is where the concept of cash burn becomes crucial. To make it as a company owner, you need to know your burn rate– a survival metric and learn how to monitor your financial runway.
What is the burn rate?
A business's burn rate is the rate at which it spends its funds. Burn rates have two types:
Most new businesses spend their first years investing in product development and client acquisition rather than generating a profit. So, what burn rate means for a startup is how quickly it is eating through its venture capital funding to pay for its fixed costs before it begins to generate a profit. Hence, it represents a measure of monetary outflow.
How does the burn rate work?
The runway, or time a company has before it will go bankrupt if it continues to operate at its current pace of spending, may be calculated using a burn rate. The length of a company's runway, in months, is just the cash on hand divided by the monthly burn rate.
When the net burn rate is positive, the business uses more cash than it brings in. The enterprise may raise income or decrease expenses to achieve a negative burn rate. If the burn rate is not reduced before all available funds are used up, a business must be suspended while other financing options, such as further investments or loans, are sought.
In addition, potential backers compare the company's current burn rate to projections made in the business plan. Only businesses with a reasonable probability of profit will get their investment capital. After investing, shareholders still need to know the burn rate to monitor the company's performance. Investors will expect answers about why the company loses money if the burn rate keeps rising.
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Formulas to calculate burn rates
The formula for burn rates, based on which one you're trying to calculate, formulas can differ. The monthly loss is found for the net burn rate by deducting operational expenditures from revenue. This demonstrates how much money the firm requires to keep running for a specific time. Yet, one aspect that must be managed is revenue volatility. The burn rate might rise even if expenses remain the same and revenues decrease. To get the net burn rate, use the following formula:
The company's running costs, including salary, utilities, and rent, must be included in the gross burn rate. Regardless of the company's income, this gives insight into its efficiency and the factors contributing to costs. The gross burn rate is determined using the following formula:
How to determine the burn rate for your company?
A successful financial plan for one business does not guarantee success for another. Consider your burn rate in the context of your company's expansion by studying key parameters like burn per department and burn per recruit. If your firm has the financial wherewithal to launch into a development phase, you can explore boosting your gross burn rate over a particular time frame to fuel that growth. However, if you don't have the capital available, you should rethink your business expansion strategy and keep your burn rate constant. This is true notwithstanding your comfort level with risk and the promise of the business.
However, given the current state of affairs, the business should maintain a cash runway of at least six months. Maintaining a burn rate with fewer than six months of runway means a business needs to prepare for fluctuations in income or expenses. Monthly expenditure shouldn't be so high that it exposes the company's minimal capital and threatens its ability to keep running for the following six months.
Keep the burn rate in check
Startups that can keep their burn rate low will be better prepared for the future. Focusing on expansion to increase economies of scale is one way to reduce a company's burn rate to a more manageable level. Reducing the workforce or cutting pay and prioritizing expanding the clientele base via advertising are two other ways of saving costs or increasing revenue to minimize burn rate.
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