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urn rate is important for any small business owner to understand, as it measures how quickly a business is spending its available capital. It is a useful metric for measuring the sustainability of a business and can help provide insights into the health of a company’s cash flow.
A higher burn rate means that a business is using up its capital more quickly and is at risk of running out of money sooner. On the other hand, a lower burn rate indicates that a business is spending its money more slowly and is likely to remain solvent in the long term or has the wiggle room to invest in other areas. Burn rate can be used as a key performance indicator (KPI) to ensure that your business is on track to reach its goals.
If you’re a small business owner unfamiliar with the concept of burn rate and its implications, stay tuned as we explain how you can measure and assess this metric to help make informed business decisions.
What is burn rate?
Burn rate is a term used to describe the rate at which a company spends its available cash, typically expressed as a monthly or quarterly rate.
Burn rate is a useful metric for investors and business owners because it provides a snapshot of the company’s financial health and can help determine if a company is spending too much or too little. Burn rate can also be used to track a company’s progress toward achieving its operational goals.
As a small business owner, knowing your company’s burn rate can help you:
- Understand how long your cash reserves will last: Knowing your burn rate will help you understand how long your business can sustain its current operations with existing cash reserves. This will help you determine when additional capital should be sought and how long you have to explore other financing options.
- Monitor cash flow: Your burn rate can be used to track your company’s cash flow. By keeping an eye on changes in your burn rate, you can quickly identify any issues with cash flow.
- Identify areas to reduce expenses: Your burn rate can help you identify areas of your business where you can reduce expenses in order to stay within your budget.
How to calculate burn rate
There are two distinct variants of burn rate: gross and net. Gross burn rate is the total amount of money expended every month, whereas net burn rate is the amount of money that is being lost each month, taking into account any potential revenue sources.
Gross burn rate
What is burn rate in relation to expenses? A small business’s gross burn rate represents its operating costs. It is calculated by adding together all expenses during a given time period (typically one month) and gives insight into a company's cost structure and efficiency, regardless of its revenue.
Total Monthly Operating Costs = Gross Burn Rate
For example, Sugar & Spice Bakery pays $2,500 per month in rent, $5,000 in wages, $1,000 in utilities, and $1,500 in miscellaneous overhead.
Their monthly gross burn rate is $10,000.
Net burn rate
Net burn rate is the amount of money a business spends in excess of its income over a given period of time. It is calculated by subtracting the company's total revenue from its expenses during a specific period.
(Monthly Revenue - Production Cost of Services/Products Sold) - Gross Burn Rate = Net Burn Rate
In January, Sugar & Spice Bakery brought in $10,000 in revenue. They spent $3,500 on ingredients and supplies to make their cupcakes, cookies, and cakes in addition to their gross burn rate of $10,000.
($10,000 - $3,500) - $10,000 = Net Burn Rate
$6,500 - $10,000 = -$3,500
Sugar & Spice Bakery has a net burn rate of $3,500. In other words, they’re spending $3,500 more per month than what they’re bringing in.
But in February, Valentine’s Day gives the bakery a huge boost in sales. Their revenue for the month is $20,000, and they spent $5,000 on ingredients and supplies for their sweet treats, on top of the regular monthly gross burn rate of $10,000.
($20,000 - $5,000) - $10,000 = Net Burn Rate
$15,000 - $10,000 = $5,000
Sugar & Spice Bakery has a net burn rate of -$5,000, making them profitable for the month (profitable companies have a negative net burn rate because they’re bringing in more money than they’re spending).
Factors that affect burn rate
Your company’s burn rate can be influenced by a variety of factors, including:
- Cash flow: Poor cash flow can lead to a high burn rate.
- Market conditions: A slow economy generally means fewer sales and less money coming into the business, which can result in higher burn rates.
- Overhead expenses: If overhead expenses are too high, a company’s burn rate will increase.
- Product pricing: If a small business sets its prices too high or too low, it may not be able to generate enough revenue to cover its expenses, leading to a high burn rate.
- Growth rate: If a business grows too quickly, it may not generate enough revenue to cover its expenses. This can lead to a higher burn rate.
As Sugar & Spice Bakery exhibited, burn rates fluctuate. This is why it’s important to continuously monitor your burn rate as a business owner and anticipate changes based on industry trends, seasonality, outside influences, and more.
How burn rate relates to cash runway
Cash runway is a company's time before it runs out of cash, assuming its current spending rate continues. It is typically measured in months.
What is burn rate’s relationship to cash runway? Burn rate and cash runway are directly related; a higher burn rate will lead to a shorter cash runway, and a lower burn rate will lead to a longer cash runway.
The cash runway formula divides the total amount of cash on hand by the average monthly cash burn rate in its basic numerical form.
Total Capital ÷ Monthly Operating Expenses = Cash Runway
Sugar & Spice Bakery was generously funded by an angel investor and has $50,000 in total cash reserves.
50,000 ÷ 10,000 = 5
Based on its current operating expenses, Sugar & Spice Bakery has a five-month cash runway.
As a small business owner, knowing your cash runway helps you identify areas where you can make adjustments to optimize cash flow and improve cash management. It gives you a better understanding of your current financial situation and allows you to plan for upcoming expenses and investments.
Most importantly, knowing your cash runway reduces the risk of running out of cash. It gives you a better understanding of when you need to raise funds or adjust your budget to stay afloat.
Amid the COVID-19 downturn, the majority of startup entrepreneurs indicated they had less than six months of funds left, otherwise known as the "runway red zone."
Pro tip: Most experts recommend having a cash runway of at least 12 months, though closer to 24 months is ideal.
How to improve your burn rate
Managing your burn rate is an important part of running a successful business. The following tips on how to improve your burn rate can help you save money, make the most of your resources, and ensure that you operate within a sustainable budget.
Tip #1 - Identify and reduce costs
Identifying and reducing costs is one way for a business to improve its burn rate. By proactively identifying areas of wasteful spending and taking steps to reduce them, a small business can free up more of its funds for other investments, such as marketing and growth initiatives. In addition, reducing costs can help a small business to better manage its cash flow, making it more resilient in the face of economic downturns and other challenges.
Small businesses can identify and reduce costs by conducting a cost-benefit analysis of their operations. This involves looking at each expense, assessing its value, and determining whether or not it is worth the cost. Areas to consider include labor, overhead, inventory, and marketing costs.
Additionally, small businesses can save money by negotiating better prices with vendors, eliminating unnecessary expenses, and implementing cost-saving processes and technologies (e.g., automated invoicing and billing or energy efficiency programs).
Tip #2 - Increase revenue
Increasing revenue can help improve a company’s burn rate by bringing in more money that can fund new products, pay for additional staff, and fuel growth initiatives.
Small businesses can increase revenue by focusing on their most profitable products or services, pricing their offerings competitively, and building relationships with customers.
Additionally, small businesses should take advantage of opportunities to upsell or add on additional items, streamline their operations to reduce costs, and use digital and social media channels to reach new potential customers.
Finally, businesses can look into other strategies to increase revenue, like subscription services and loyalty programs.
Tip #3 - Obtain additional funding
Obtaining additional funding can help to improve a company’s burn rate by providing extra resources for scaling up operations and a financial cushion for unexpected expenses.
Additional funding could also help provide more runway for a small business, allowing it to develop and grow for longer without worrying about running out of cash.
Small businesses can obtain additional funding to decrease burn rate by applying for a bank or credit union loan, seeking investments from venture capitalists or angel investors, or applying for a grant from a government or non-profit organization. Remember to account for the cost of funding (i.e. loan payments) in your gross burn rate calculations)
Additionally, small businesses can look into crowdfunding platforms, such as Kickstarter or GoFundMe, or ask friends and family for investments to raise additional funds.
Pro tip: It is important to thoroughly research the terms and conditions of any type of funding before signing any documents.
Key takeaways
- Burn rate is a term used to describe a company’s rate of spending or operating costs.
- Burn rate is typically expressed as a monthly rate and can give an indication of how much runway a company has before it needs to raise more capital or undergo drastic budget changes.
- Burn rate is important for small businesses because it helps them to avoid financial difficulties and keep their business running.
- A small business can reduce its burn rate by identifying and reducing costs, increasing income, and obtaining additional funding.
Burn rate is a critical metric for any small business, and understanding it is key to ensuring long-term financial health and success. It’s important to not only track burn rate and analyze it on a regular basis but also to have an understanding of what it’s telling you.
By having a good grasp of your burn rate, you can make informed decisions to ensure your company’s long-term success. Learn how Novo can help you stay on top of your company’s burn rate with a free business checking account designed just for small business owners.
Novo Platform Inc. strives to provide accurate information but cannot guarantee that this content is correct, complete, or up-to-date. This page is for informational purposes only and is not financial or legal advice nor an endorsement of any third-party products or services. All products and services are presented without warranty. Novo Platform Inc. does not provide any financial or legal advice, and you should consult your own financial, legal, or tax advisors.
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