Tuesday, 27 October 2020

Understanding Burn Rate & How to Calculate It

Understanding Burn Rate & How to Calculate It
04 May
1:49
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Getting a business up and running can be exciting for entrepreneurs, but it’s not as thrilling to think about the money you’re spending in the process. Keeping an eye on your burn rate can help you make sure your cash isn’t flying out the window faster than you realize.

While startups use burn rate to figure out how much capital is needed to launch their businesses, companies of all types and sizes can rely on the same calculation to manage spending and costs, no matter how long they’ve been established. Continue reading to find out how understanding burn rate can benefit your business.

What is burn rate?

Burn rate is the degree to which a company spends its cash during a specified period of time, said Jack McGourty, a professor and director of community and global entrepreneurship at Columbia Business School.

“How much money are you burning through, especially as it relates to any money that is coming into the company through operations or loans?” he said.

For startups, burn rate can indicate how much financing the business could secure from sources like investors. Venture capitalists may provide funding based on how fast the business plans to spend it.

According to McGourty, burn rate could also forecast when a new business will become profitable. As he noted, you’d want to determine when you plan to hit revenue goals that match or exceed your burn rate. He added that established businesses can use this approach to find out when a new business initiative or product line will begin making money, compared with development costs. You could calculate the individual burn rate of the new vertical.

“Think of the burn rate, whether it’s a new company or an existing company, as the pace that it’s spending whatever money they’ve set aside to fund this new venture,” he said.

How to calculate burn rate

Burn rate shows your company’s negative cash flow and is typically calculated on a month-by-month basis using the actual amount of money in your account. Your burn rate would be expressed as a figure, such as the specific amount of cash that you’re spending, McGourty said.

You can find both net burn rate and gross burn rate, depending on the information you’re seeking. Gross burn rate would show your company’s operating expenses, while net burn rate would illustrate how fast the business is losing money.

Gross burn rate

Your gross burn rate is simply your operating expenses. You would add all operating expenses, like rent, utilities and other overhead. The total would indicate how much money the business is spending on a monthly basis, regardless of revenue.

Net burn rate

Revenue would come into play when calculating net burn rate. You would subtract your total monthly operating expenses from your monthly revenue to find out how much cash the business needs to stay open each month, which would be your monthly operating losses.

For example, say your business generates $2,500 each month but you need $5,000 to cover your monthly operating expenses. You would have a net burn rate of $2,500. Until the business begins generating positive cash flow where revenue exceeds expenses, your net burn rate would be high, McGourty said.

Net burn rate would give you a better idea of how much money you’re losing each month, which would indicate your runway, or how long the business could survive based on your current spending rate. To calculate your runway, you would divide your cash by your monthly losses. For instance, if you have $50,000 in the bank and you spend $5,000 each month without bringing in additional money, your funds would run dry in 10 months.

Similar calculations to know

There are several ways to analyze your company’s finances to watch your spending as it relates to your revenue. Here are a few other accounting terms and formulas to understand as a small business owner.

Operating cash flow

The amount of money generated through regular operating activities in a specific period of time is considered operating cash flow. You would add your net income and any non-cash expenses, like depreciation of an asset, then subtract any increases in your working capital, which is the money allocated for short-term bills and regular business operations.

Operating cash flow = (Net income + Non-cash expenses) – Increases in working capital

Break-even point

The amount of revenue you need to generate or the number of product units you need to sell to cover the cost of making the sale would be your break-even point, or BEP. The BEP would indicate a period of time when revenue equals expenses. It would also show when or if a product or service could become profitable. You could find your BEP in terms of product units or dollars. The unit-based calculation would be necessary to complete the dollar-based formula.

To calculate the break-even point in units:

Break-even point [units] = Fixed costs per unit / (Revenue per unit – Variable cost per unit)

To calculate in dollars:

Break-even point [sales in dollars] = Fixed costs per unit / (Sales price per unit x BEP in units)

What your burn rate says about your small business

Without money to cover operating expenses, a business likely won’t survive. Calculating your monthly burn rate would show you how fast you’re depleting your cash, and whether that rate is sustainable for the business, McGourty said.

“If you’re spending money faster than you’re making it, there’s going to be an end in sight,” he said.

Once you understand how much money you need to operate the business, as well as the speed at which you spend that money, you would be in a better position to ask for the appropriate amount of financing from a small business lender or investor, McGourty said. Based on your analysis, you would know how long that funding would last.

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How to improve your burn rate

Increasing revenue would ultimately improve your company’s burn rate, McGourty said, as would reducing your expenses. Here are a few strategies for improving cash flow to lessen the amount of money you’re burning through each month.

Customer retention: Consider ways you can encourage your existing customers to make more purchases, whether it’s through upselling or creating a new product line, McGourty said. It’s typically more profitable to retain customers rather than to find new ones, which often requires additional – and sometimes costly – marketing efforts, McGourty said.

Assess your accounts payable: You may be able to adjust your payment schedule to vendors, such as moving from a 30-day billing cycle to a 60-day schedule, McGourty said. This change could help you better manage cash flow each month.

Reduce operating costs: Analyze your variable and fixed costs to see what you can cut, said McGourty. For instance, you could try to negotiate a better price with one of your vendors, or you could move into a smaller office space with lower rent.

Manage sales cycle: The time it takes for you to close a sale can affect your cash flow and burn rate, as you would be spending money and resources on engaging the customer until they pay you, McGourty said. Try to reduce the amount of time it takes for a customer to buy an item or pay you for a project after your first interaction.

As a small business owner, you should regularly engage in this type of evaluation of your costs and spending habits, McGourty said. Analyzing burn rate in addition to your routine calculations can give you a clearer look at how fast you’re draining your cash reserves, so you can reduce that spending before it’s too late.

“You always want to monitor expenses,” he said. “It’s so important that [business owners] understand how much cash they need before they break even, so they have enough money to sustain the basic expenses in the meantime.”

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Melissa Wylie

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