What is Burn Rate?
Burn rate is the rate at which a business spends money. It’s typically used by new businesses to track how much they spend in venture capital funding before creating their own positive cash flows. It is a measurement of negative monthly cash flow.
For example, a company that has a burn rate of $500,000 means it spends $500,000 per month.
Venture capitalists and new investors can look at burn rate to decide if they should invest in a company. Companies with high burn rates go through funding quickly and may be a bit riskier to investors. Those with low burn rates are more careful with funding and can be safer to invest in.
What are the two types of burn rates?
The two types of burn rates are gross burn rate and net burn rate. Gross burn rate is equal to the business’s monthly operating costs. Net burn rate measures the monthly rate a business loses money overall.
Let’s look at an example to help further understand the difference. A new fitness center called Fun Fitness opens and has already purchased all needed equipment. It spends $25,000 in monthly rent, $12,000 in monthly wages, and $1,000 in monthly utilities. Its gross burn rate is $38,000 (25,000 + 12,000 + 1,000 = 38,000). This means it spends $38,000 every month.
However, Fun Fitness generates $25,000 in monthly gym memberships and has a cost of goods sold of $5,000. To calculate its net burn rate, subtract its monthly revenue by the cost of goods sold. Then, subtract its gross burn rate and eliminate the negative sign in the result. Fun Fitness’s net burn rate is $18,000 [25,000 - 5,000 - 38,000 = (-18,000) x (-1) = 18,000].
How is burn rate related to cash runway?
Cash runway is the amount of time a business has before it runs out of money. You can calculate cash runway by dividing a company’s total cash balance by its net burn rate. For example, a company with a cash balance of $204,000 and a net burn rate of $17,000 has a cash runway of 12 months (204,000 / 17,000 = 12).
How can a business decrease its burn rate?
There are several ways a business can cut down on its monthly expenses while it’s getting started. First, it can find more creative ways to market inexpensively. For example, instead of paying thousands of dollars in online advertising costs, a company can use search engine optimization (SEO) to increase its organic website traffic at a lower cost.
A company can layoff unnecessary employees if its burn rate gets too high. It can negotiate cheaper rents, reduce utility usage, or decide to pay lower wages in the short term. It can also use economies of scale or scope to increase profitability or drive more sales. Generating more revenue counteracts a high gross burn rate, creating a lower net burn rate.
Burn rate is the amount of money a business spends per month. Startups often use burn rate to measure how quickly they are running through venture capital funding.
Gross burn rate simply measures a business’s monthly operating expenses. Net burn rate incorporates cash inflows to reveal the overall monthly rate at which a business is losing money.
Net burn rate is used in conjunction with cash balance to calculate a business’s cash runway. This shows how much time a business has before running out of money. A company can decrease its net burn rate by reducing costs or increasing monthly revenue.