What Is Burn Rate and How Is It Calculated?
Your Burn Rate Can Tell You If Your Business Can Survive
Burn rate is a concept that every entrepreneur must become familiar with. It's a key measure of sustainability, or how long your business can stay afloat until sales rise. Stated differently, how long can your company operate until you run out of money.
The term is usually used in connection to a start-up and indicates the rate at which your company is consuming, or burning, its financing or store of venture capital to support operations in excess of cash flow. It's a measure of negative cash flow, and it is most often expressed in months, though in a crisis it might be measured in weeks or days.
For instance, let's say your company needs $5000 every month to keep the lights on, but sales are only $2500 for the same period. You are then burning $2500 a month.
Why Does Burn Rate Matter
There are two good reasons that burn rate matters. The first is that it tells you when you're going to run out of money.
The second is that investors look at a start-up companies burn rate and measure it against future revenues of the company to decide if the company is a worthwhile investment. If the burn rate is greater than forecast or if the company's revenues are not growing as rapidly as they are forecast to grow, then investors may think the company is not a good investment. It may be too risky.
You should calculate watch your burn rate carefully, as many businesses, such as those in technology, may take a long time to find their market and become profitable.
Calculating Burn Rate
Analysis of cash consumption, or burn rate, will tell you (and your investors) whether your company is self-sustaining, or whether you need additional funds. There are several advanced ways of calculating the burn rate, but here's a really simple, practical one.
- Let's focus on a period of time, such as a quarter. What's the difference in your cash balance at the beginning of the quarter and at the end of the quarter? So if you started with $10,000 "in the bank", and at the end of the quarter, you have $4000 you burned $6000.
- Divide by the number of months in the period of time you selected. There are three months in a quarter, so your company burned $2000 a month.
If you want to stay in business, sales must rise to generate at least $2000 a month. Of course, if you have planned acquisitions coming up, your burn rate going forward will be higher.
XYZ, Inc. is a start-up technology company located in Silicon Valley. It has just been granted venture capital funding for a software product it is developing. The terms of the venture capital funding give XYZ a certain number of years to break even or become profitable. XYZ wants to burn through the cash from the venture capital firm as slowly as possible. After that cash is gone, it will need to apply for more venture capital funding, loans, or do an initial public offering to stay afloat. Thus, understanding, calculating and managing their burn rate is essential to their survival.