Burn rates can provide valuable insights into a business’ financial health and sustainability, and can help investors and stakeholders make informed decisions about the business’ future.
In this article, we’ll explore what burn rates are, why they matter, and how businesses can manage them effectively.
What is burn rate?
Burn rate refers to the rate at which a business is spending its available funds to cover its expenses. In other words, it is the rate at which a business is “burning” through its cash reserves.
Burn rate is often used as a measure of a business’ financial health and sustainability, particularly for startups and entrepreneurs that are using investor funds to fuel their growth. By tracking their burn rate, these businesses can better understand how long their current funding will last and can make better decisions about future fundraising or cost-cutting measures.
How to calculate burn rate?
Burn rate can be calculated in a few different ways, depending on the specific metrics and time periods being used. In this article, we will assess the two most common; gross burn rate and net burn rate are the most used across the financial world.
1. Gross burn rate
The gross burn rate measures the total amount of cash a business is spending each month, including both operating expenses and capital expenditures. To calculate the gross burn rate, you would take the total amount of cash a business has on hand (its cash balance) and divide it by the monthly burn rate. The formula for calculating gross burn rate is:
Gross burn rate = cash balance / monthly burn rate
For example, if a business has $1 million in cash and is spending $100,000 per month, its gross burn rate would be:
Gross burn rate = $1,000,000 / $100,000 = 10 months
This means that the business’ cash reserves would last for approximately 10 months at its current spending rate.
2. Net burn rate
The net burn rate measures the amount of cash a business is losing each month, after taking into account any revenue it is generating. To calculate the net burn rate, you would subtract the monthly revenue from the monthly expenses. The formula for calculating net burn rate is:
Net burn rate = monthly expenses – monthly revenue
For example, if a business is spending $100,000 per month and generating $50,000 in revenue, its net burn rate would be:
Net burn rate = $100,000 – $50,000 = $50,000 per month
This means that the business is burning through $50,000 in cash reserves each month, after taking into account its revenue.
What can affect burn rates?
Understanding the factors that affect burn rate can help business manage their expenses and make informed decisions about their financial future. See some of these below:
Revenue
A business’ revenue can have a significant impact on its burn rate. Businesses that are generating high levels of revenue may be able to sustain a higher burn rate than those that are not. Conversely, businesses with low revenue may need to reduce their burn rate to conserve cash.
Expenses
A business’ expenses are a major driver of its burn rate. Businesses that are spending heavily on things like salaries, marketing, and product development will have a higher burn rate than those with lower expenses.
Funding
A business’ investors and funding sources can also impact its burn rate. Businesses that are relying on outside investment to fund their growth will need to be mindful of their burn rate to ensure that they are using their funds effectively.
Growth stage
A business’ growth stage can also influence its burn rate. Early-stage businesses may have higher burn rates as they invest in product development and marketing to gain traction in their markets. Later-stage businesses may have lower burn rates as they focus more on scaling their operations and generating revenue.
Industry
Burn rates can vary significantly across different industries. For example, software startups may have relatively low burn rates compared to biotech startups, which often require significant investments in research and development.
By understanding these factors and how they can impact burn rates, businesses can make more informed decisions about their spending and financial planning.
What is a good burn rate?
There is no one-size-fits-all answer to what constitutes a good burn rate, as it can vary widely depending on factors such as a business’ industry, growth stage, funding sources, and revenue. In general, a sustainable burn rate is one that allows a business to continue operating while also conserving its cash reserves for future growth.
When starting financial planning as a startup, a burn rate of 18-24 months is often seen as a reasonable target. This means that the business’ current cash reserves would last for 18-24 months at its current spending rate. However, even within the startup world, burn rates can vary widely depending on the business’ business model, growth goals, and competitive landscape.
Ultimately, what constitutes a good burn rate depends on a range of factors specific to each business. It is important for businesses to regularly evaluate their burn rate in the context of their broader financial goals and adjust their spending accordingly to ensure they are on track to achieve long-term success.
How to reduce burn rate?
Reducing burn rate involves managing expenses strategically to extend your business’ financial runway – all while maintaining the ability to grow. The goal is not to just cut costs, but to spend more efficiently and align resources with business priorities.
Here are several practical ways to reduce burn rate:
- Evaluate business spending: Identify non-essential expenses, such as travel, that can be paused or eliminated without impacting core operations.
- Renegotiate contracts and terms: Work with your suppliers to secure better rates or more favourable payment schedules that improve cash flow.
- Optimise your hiring: Ensure new hires directly support critical goals, and consider cross-training existing team members to increase efficiency.
- Improve business efficiency: Automate repetitive tasks and streamline workflows to reduce wasted time and resources.
- Monitor financial metrics closely: Regularly track monthly expenses, cash burn, and runway to spot trends early and make proactive adjustments.
- Explore additional revenue opportunities: Even modest increases in income can meaningfully reduce net burn.
Ultimately, lowering burn rate is about maintaining financial discipline and making deliberate choices that strengthen long-term sustainability while preserving the ability to invest in growth.
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Managing burn rates with financial modelling tools
The right financial modelling tool can be a valuable resource for businesses looking to manage their burn rates effectively. These tools can help businesses project their future cash flows and identify potential financial risks and opportunities. Here are some ways financial modelling tools can be used to manage burn rates:
- Forecasting: Financial modelling tools can help businesses create detailed financial projections based on a range of variables, including revenue, expenses, and funding sources. By projecting their future cash flows, businesses can better understand how changes in their spending and revenue will impact their burn rate over time.
- Scenario analysis: Financial modelling tools can also be used as a scenario analysis tool, which involves modelling different outcomes based on different assumptions. For example, a business could model the impact of reducing its expenses or increasing its revenue to see how these changes would impact its burn rate.
- Sensitivity analysis: Sensitivity analysis is a type of scenario analysis that involves testing how changes in individual variables impact overall financial outcomes. For example, a business could model the impact of changes in its revenue or expenses on its burn rate to identify the variables that are most critical to its financial health.
- Capital planning: Financial modelling tools can also be used to help businesses plan their capital needs over time. By modelling different funding scenarios, businesses can identify the most effective ways to raise capital to support their growth while minimising their burn rate.
By using financial modelling tools to manage their burn rates, businesses can make more informed decisions about their financial future and reduce the risks associated with unsustainable spending. However, it is important to note that financial modelling is not a perfect science, and businesses should be prepared to adjust their projections and assumptions as new information becomes available.
