Cash moves the economy. Businesses need it to operate, and they need a lot of it. Cash burn rate helps a company see how much cash is essential to stay open. Not only that, it tells how quickly money reserves are being spent. The rate shows how long a business can last before it becomes insolvent. It is used more in the context of start-ups, but all companies should track cashburn.
In this article we will:
- Explore what a cash burn rate means
- Give an example of the cash burn rate formula
- Explore cash runway
- Show how to calculate cash runway
- Give 7 ways to manage high cashburn.
What is Cash Burn Rate?
It is a measurement of how quickly a business is losing money, or rather burning cash. It tells how long they can run operations, while paying needed expenses. The calculation considers cash flow, operational costs, and sometimes revenue. Typically, accruals are NOT counted since it is a measurement of literal cash.
Calculating Cash Burn Rate
The equation is commonly expressed in terms of months. Generally, there is a focus on calculating the burn rate for a quarter (3 months). However, you can measure any amount of time. Here is the cash burn rate formula.
Gross Burn Rate
There are two different types of cash burn rate formulas: gross and net. We view gross burn, as more relevant to small business owners actively seeking funding. It measures total cashburn on operating expenses alone. Included items are: payroll, rent, utilities, taxes, etc. With net burn revenue is included in the formula. However, in the early stages of growth, revenue just isn’t consistent enough to consider.
This is how you calculate gross cash burn rate:
Gross Burn Rate = (Starting Balance – Ending Balance)/# of Months
Gross Burn Rate Example: You are a company beginning the quarter with $1,000,000 in the bank account, and ending the quarter with $700,000.
Gross Burn = ($1,000,000 – $700,000)/3 months in the quarter = $100,000
Taxiing the Runway
Part of measuring burn rate is calculating cash runway, or the life expectancy of a company. It is how many months a business can stay open, at current spending. So too much money is never enough, right?
Well actually in terms of funding rounds, balance is the name of the game. If you don’t fundraise enough, the business is left with a short runway, risking death. Trying to raise more than needed, for a long runway, is a waste of resources and equity. Common practice is to raise enough money to last 18 months. This gives you a year to generate profit, and a cash runway of 5+ months to look towards more investors.
Here is how to calculate cash runway:
Cash Runway = (Cash in the Bank) / (Monthly Burn Rate)
Cash Runway Example 1: If a company has $700,000 in the bank and is spending $100,000 per month. They have a cash runway of 7 months.
Runway = $700,000/$100,000 = 7 months
It is recommended to calculate runway conservatively, as shown above. Note: there are companies who will add accounts receivable to cash in the bank. In this case, a company has trust from a bank. In the form of a loan, the bank will cover the sum of accounts receivable. So accounts receivable acts as cash in the bank.
Runway = (Cash in the Bank + Accounts Receivables) / (Monthly Burn Rate)
Cash Runway Example 2: If a company has $700,000 in the bank, $85,000 in accounts receivables, and is spending $100,000 per month. They have a cash runway of 7.85 months.
Runway = ($700,000 + $85,000)/$100,000 = 7.85 months
Being Strategic with Cashburn
As a business starting out you want to be strategic about your cash flow. Understanding how much money you spent in the past, will influence future needs. Company size determines how you factor burn rate into your accounting. A startup burn is monitored for business solvency. While an established business limits cashburn so they have money to apply towards potential investments.
Startup Burn Rate
Funding is important. Start-ups fail because they run out of money, or an investor drops out. It takes awhile for start-ups to become profitable and they spend heavily. They go through several rounds of funding in the first few years of operation, while working to be self sustainable.
Cash burn rate will signal cash needs for the next round of funding. Additionally an investor looks at gross burn to see how freely the startup is spending. With high startup burn, they aren’t managing cash flow wisely; low cash burn, they are afraid to invest aggressively. The goal is to find a happy medium.
For companies NOT seeking funds, burn rate reflects how long they can operate at a loss. High cashburn would signal an urgency to increase revenue. It might also mean the business has an investment, with a future return on interest (ROI). A low cashburn could mean they are missing out on valuable revenue streams. Established companies should strive for an infinite burn, meaning having no burn. It will keep the business cash positive and doors open.
High Cash Burn Rate
As a business owner, you should be burn-aware. With spending on your radar, it better atunes you to your cash flow. Don’t be dismayed, high cash burn may not be a bad thing! Spending levels will increase as you move through growth stages.
Also this rate is only a reflection of the period in question. The picture could look very different in the next month, quarter, year, and two years out. Burning cash isn’t an issue if you: maintain clean books, spend wisely, and watch your cash runway.
If you have a large amount of cash in the bank + an untapped credit line + a rapidly growing revenue line + large, supportive venture capitalists + a reasonable valuation…then you may consider keeping burn rate slightly higher as a way of expanding your business while your competitors can’t…I call this ‘using your balance sheet as a strategic weapon.’ – Mark Suster Venture Capitalist
How to Manage High Cash Burn
In the event that spending is out of control. Here are 7 ways to manage a high cash burn rate.
1. Cut Costs
The best way to manage your cash flow is to cut costs. Analyze your spending. What is absolutely needed in order for you to do business? Assess and eliminate the leakage. Next figure out what costs are controllable. Certain expenses have savings potential: travel, office space/equipment, and bill pay. Explore different pricing and negotiate rates.
We are living in an age where automation is available, and it can save money. Consider automating inventory management, invoicing/billing, payroll, email, etc. Anything that is repetitious and doesn’t require creative problem solving.
Paying salaries comes with high overhead. Transferring wages to contract labor is resourceful. Re-evaluate the positions you absolutely need by your side. Outsource the rest.
4. Review revenue streams
Warning! Don’t be delusional about a high cashburn. If you have a product that doesn’t fit in the market, that is an issue. You will not drive growth on the belief that a product sells. Without market research, endless spending will be fruitless.
5. Reduce business credit lines.
Credit card companies have appealing offers for business owners. But with a business credit line you increase the chance of unnecessary expenses. Furthermore there should be a limit to how many people can use credit cards. This will give you more control on spending and interest rates.
6. Cash Forecasting
A cash forecast will help you determine a company’s ability to manage large expenses coming up. Not all transactions run in a linear fashion. For example you could have a large annual renewal for all your Salesforce licenses. Forecasting helps you avoid cash crunches and has the potential to increase cash runway!
7. Look for more funding
When you are going through rounds of investments, you need to keep a schedule in mind. Typical rounds happen anywhere from 1-2 years. Meaning investors will give you money to last 2-3 years. Start negotiating with investors sooner rather than later.
A Balanced Burn is the Sweet Spot
Now that you have the cash burn rate formula under your belt, you can keep course on your runway. As a small business owner, calculate your burn rate early and often. This will give you a better view of your cash flow, and have investors knocking at the door. If you are burning cash, practice the management tips in this article to get spending under control. Ultimately you want to strike a nice balance between operational expenses and business investments. At least until the company is self-sustainable.