Burn rate is the amount of money your business needs in a certain period — usually a month — to cover all expenses. In other words, it tells you how quickly your business “burns through” capital.
Typically, new businesses use the burn rate to find out when they'll run out of startup capital. This tells them how long they have until they need to be profitable. However, all businesses, regardless of how new they are, can benefit from knowing their burn rates.
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Why is burn rate important?
Investors look for low burn rates when new businesses seek startup capital. That's because a low rate indicates investment dollars will go further. New companies with a low burn rate are more likely to gain traction and become profitable. This yields a return on investments.
The metric is also essential for well-established businesses. The lower your business’s burn rate, the more likely it will survive slow seasons. A low burn rate is an indicator of a strong cash position. And a strong cash position is a vital indicator of a business’s health.
A company can be profitable on paper and still fail due to a lack of cash. A low burn rate helps make sure this doesn’t happen to your business.
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Burn rate formula
There are several different ways to calculate burn rate. Some are more complicated than others, but all of them tell you how quickly your business is using up its cash reserves. So let’s look at the most straightforward burn rate calculation:
(Starting Cash - Ending Cash) / Number of Months = Monthly Burn Rate
How to calculate burn rate
To calculate your burn rate, you’ll need the balance sheet for the period you’re assessing and a calculator. Next, follow these four steps:
- Define the period you will be assessing (burn rate is a current metric, so you want to look at a recent period).
- Find your cash balance for the beginning and end of that period. Refer to your balance sheet to find these amounts. Don’t use your bank statement — it doesn't include uncleared checks or deposits. Subtract your ending cash balance from your beginning cash balance.
- Divide the difference by the number of months you’re assessing.
You typically calculate burn rate monthly. But you may want to use a longer time period to get a more accurate calculation.
This will help you capture expenses that don’t occur monthly. It will also help make sure extraordinarily good (or bad) sales months don't skew your calculations.
Burn rate example
Company X is reviewing the burn rate for the first quarter of the year in early April.
Company X’s cash balance on Jan. 1, the first day of the quarter, is $160,000. Its cash balance on March 31, the last day of the quarter, is $100,000.
- Starting Cash: $160,000
- End Cash: $100,000
First, you subtract the ending cash balance from the beginning cash balance:
$160,000 – $100,000 = $60,000
Next, divide the difference by the number of months you are assessing. In this example, that number is three:
$60,000 / 3 = $20,000
Company X’s burn rate is $20,000/month for the first quarter of the year.
Potential investors might prefer to use different calculations that only consider operating expenses. However, the calculation above should be sufficient for most small businesses. It considers operating expenses as well as other costs, like loan payments and owner’s draws.
Burn rate and cash runway
Your cash runway measures how long your cash will last at your current cash burn rate. The higher your cash runway — or the lower your burn rate — the more likely it is your business will survive.
Most small business owners don’t like to think about a scenario where their business might run out of cash. But this is a real possibility. Several things can cause it to happen:
- Downturn in sales.
- Upswing in expenses to promote growth without enough capital to back those expenses.
- Slow collections.
Cash runway formula
To calculate how many months your business can operate on your existing cash reserves, use this cash runway formula:
Current Cash / Monthly Burn Rate = Cash Runway
Continuing with our earlier example with Company X:
$100,000 (ending cash for the 3-month period) / $20,000 (burn rate) = 5 (runway)
If sales and expenses stay the same, this business has enough cash to sustain it for five months.
How to improve your burn rate
There are several simple ways to decrease your business’s burn rate and improve your cash runway:
- Increase revenue without increasing expenses. The easiest way to do this is to improve your gross profit margin. There could, for example, be opportunities to increase your prices. Even a 1% to 3% price hike could have a considerable impact on your margins. Any improvement to your gross profit margin will help lengthen your business’s cash runway and lower your burn rate.
- Decrease your expenses. If your expenses aren't producing income, improving efficiency or making your customers' experience better, cut them out. Start by analyzing the dues and subscriptions line item on your profit and loss statement. Are you paying for subscriptions you don’t use? Another area to watch is advertising and marketing. Make sure you're getting a return on those investments. If you don’t know exactly what advertising and marketing strategies are generating revenue, you could be throwing away cash.
- Consider refinancing debt. If your debt payments are high, refinancing that debt could help improve your cash runway. It’s best to refinance debt before you need to though. Don’t wait until you are already experiencing a cash flow crisis.
- Use a cash management system to plan for positive cash flow. You can proactively plan for a low burn rate, long cash runway and positive cash flow. The Profit First cash management system can help you do this. It encourages you to prioritize savings and leave your cash reserves alone until you need them.
This article originally appeared on Fundera, a subsidiary of NerdWallet.
