What is Burn Rate?
Burn rate is one of the key metrics for entrepreneurs that have funding, but may not yet be profitable. It represents the rate that a company is using up its financial capital and no company wants to burn money like the city of Chicago or the state of California but that is another topic!
It is essential to understand burn rate as it can indicate the sustainability or short-term insolvency of a business venture.
Although it is essential for every business to monitor its burn rate, it is especially critical for startups. This is because new companies tend to incur a hefty amount of expenses in the process of getting established and creating a product. Just check out a pharmaceutical company and see how much it costs to bring a drug to market!
Failing to monitor burn rate means startups may not be able to stick to a budget, and this may affect every aspect of your operations. In other words, if you don’t know how much your company is spending, you don’t know how much money you need to raise.
A study in 2007 revealed that up to 82 percent of businesses fail due to bad money management. This is one of the reasons why it is critical to monitor the burn rate of your organization.
Burn rate varies from one company to another depending on the stage of its development and the industry that the business operates. Many things contribute to the burn rate of an organization including operational costs like the salaries of workers as well as the cost of purchasing equipment.
While some expenses are constant, others may be variable. As a rule, it is vital to have enough cash in your account to cover your costs for up to six months based on your current burn rate.
Determining the burn rate of your startup should not be left to guesswork. It should be calculated every month. The fact that your burn rate amounts to “X” this month does not mean that it will be the same in preceding months. Supposing that your burn rate will remain constant is a mistake.
How to Calculate the Burn Rate
Calculating your burn rate is a straightforward process. Add up all your expenses in a month. The figure that you get is your burn rate. Apart from your actual burn rate, you can also calculate your net burn rate and gross burn rate.
Your gross burn rate is the total amount that you are spending monthly (without any subtractions of your income). On the other hand, your net burn rate is the amount that you spend monthly minus after subtracting the amount that you make monthly.
A. Net Burn Rate: It is easy to calculate your net burn rate. Simply subtract your net income from your expenditure for the month. The total is your net burn rate. For example, if your net income in a particular month is $10,000 and you spent $30,000, then your net burn rate is $20,000.
Another way to calculate your net burn rate is to subtract your net loss from the previous month from your net loss for this month. Divide the figure that you get from your net loss for this month. The amount that you get is your net burn rate. You can make it a percentage by dividing it by 100.
So, if you spent $40,000 last month and $20,000 this month. You can calculate your burn rate like this:
$40,000 – $20,000 = $20,000.
$20,000/$20,000 = 1.
1/100 = 100. This means, your net burn rate is 0.01 or 10%.
B. Gross Burn Rate: The process of calculating your gross burn rate is not so different from the method above.
You can calculate your gross burn rate by subtracting the total amount you spend in the previous month from the total amount that you spent this month.
You then divide the total with the amount you spent this month and multiply it by 100. So, if you spent $50,000 last month, and $45,000 this month, this is how the calculation of your gross burn rate would look:
$50,000 – $45,000 = $5,000.
$5,000/$45,000 = 0.11.
(0.11 / 100) * 100 to get % = 11.11%
Based on this calculation, your gross burn rate is 11.11%.
Another way to do this is to divide your income by your monthly expenses. Therefore, if you make $30,000 monthly and your monthly expenses are $50,000. Then your gross burn rate is
$30,000/$50,000 = 0.6.
Don’t try and do this discussing over beers with your team mates at the pub. Full faculties required!
Importance of Identifying Your Burn Rate
As indicated above, determining your burn rate is very important. Here are some reasons why you need to keep a tab on your burn rate.
1. Lets you know when it is time to start raising money.
Your burn rate shows the rate that you’re losing money. Therefore, by knowing your burn rate, you can tell how long it will be before you run out of funds. This is also known as X number of months of runway. Or, how many months it will take for your startup to run out of money. Yikes, that’s something you’ll obviously want to track and keep an eye on.
For example, if your burn rate is $50,000 monthly and you have just $100,000 in the bank, then you know that you are in the red zone and you need to start raising money. Or, slow down your burn rate in any way you can to give your startup the life it needs to raise more funds.
If you do not know your burn rate, then you may continue to go about business as usual until you realize that your account is very low. In essence, knowledge of your burn rate gives you foresight in terms of managing the finances of your business.
2. Lets you know how profitable your business is.
Another significant benefit of knowing the burn rate of your business is that it lets you know if your company is profitable. Without proper analysis of your finances, it can be easy to assume that a venture is profitable when in reality it is not. Simply looking at your account balance is not enough.
Knowledge of your burn rate enables you to know how to plan your business for profitability. For example, if your burn rate is higher than your monthly income, you can make a strategic decision to increase the prices of your product or opting for suppliers that offer more affordable prices for raw materials.
3. To be on good standing with investors.
It may come as a surprise to some, but burn rate is one of the things that investors look at before deciding whether to put their money in a company especially in situations where the business is not yet profitable.
Usually, a potential investor would measure your burn rate against your projected revenue. If your burn rate is likely to be higher than your projected income in the long term, then you are likely to struggle to make a profit. This means investors are likely to wary of putting their money in your organization.
Factors That Affect Burn Rate
Businesses do not exist in isolation. Therefore, many factors may affect the burn rate of an organization.
- Global Economic Conditions: You may be thinking that global economic conditions are unlikely to affect your business, and you’d be wrong.
The economic conditions in the country that you operate and abroad can affect the amount of money you have to spend monthly. For example, if the price of commodities like gas increase (which is not happening in America because of fracking), you may have to pay more to get the raw materials that you need to create your products.
- Industry That You Operate: The money that you need to spend monthly may vary depending on the industry that you operate.
The startup costs in some sectors are higher than others. For example, if you are in the manufacturing industry, you’re likely to spend money on raw materials, machinery, rent, the salaries of your workers, and a lot more.
On the other hand, if you are in the service industry, you may only have to spend money setting up your establishment and paying your workers.
- Availability of Resources: Another critical factor that can affect your burn rate is the availability of resources.
This includes human resources as well as raw materials. If you have to import your raw materials from another country or hire experts from abroad, you may have to spend more money than if you had to source your raw materials and experts locally.
- Competition: The level of competition that your company faces also affects your burn rate. If you are operating in a highly competitive field, you’re likely to have to spend a lot of money on marketing to gain an edge over your competitors.
This contributes to increasing your burn rate. On the other hand, if you are not in a competitive field, you may not have to spend too much on marketing.
Burn rate is an important metric that every business must monitor. It plays a vital role in the overall outlook of your business and allows you to make grounded management decisions.
Failing to track your burn rate is akin to going on a road trip without checking how much fuel is in your car.
You’re likely to get stuck along the way when your fuel runs out. Just as you’re likely to end up in losses over time if your expenditure is much higher than your income. If you find that your burn rate is getting too high, you can reduce it by working to increase your revenue or reducing the size of your company.
Most articles about burn rate talk about why it is vital for startups. However, it is essential to all businesses regardless of their stage of development.