Your startup's cash burn rate is one of the most important metrics to get right. Without it, you could run out of cash.
Understanding the rate your startup is spending or losing money is necessary to ensure you have the right amount of cash reserves and be among the 80% of companies that survive in their early years.
As this is a “life or death” situation for your company, it’s important to understand what cash burn rate is and how to use them to make improved financial decisions.
What Is Cash Burn Rate?
The cash burn rate measures how quickly a company spends its cash reserves over a specific period.
Using the burn rate, you can estimate how much time your business has left to operate before running out of cash, also known as cash runway.
For a startup to survive, it must either become profitable or raise equity financing from external investors before running out of cash.
Because it may take a few years for unprofitable companies to start turning a profit, the burn rate helps you see how much time you have to achieve that goal.
Calculating Cash Burn Rate
Cash burn rate takes total cash balance from the prior month minus the cash balance in the current month to determine your current cash burn rate.
To calculate cash burn rate use this formula: Cash balance from prior month – Venture capital funding
Beware that including VC-funding in your cash burn rate calculation does not always give you a realistic view of how much money is being spent/lost, and may lead to cash burn issues down the line.
For this reason, venture capital-backed startups may wish to exclude recent VC funding from this calculation. To do so, the calculation would be:
Cash balance from prior month – Venture capital funding – Cash balance in current month – Venture capital funding = Cash burn rate, excluding Venture capital funding
Types Of Burn Rates
Gross burn rate is the total amount of cash you're spending per month.
This measurement leverages your financial reports, such as P&L, balance sheet, and cash flow statement, to determine a realistic calculation of your company’s burn.
Gross burn rate gives you a clear picture of how much cash you’re spending each month. It's also a financial metric that all venture capitalists, investors, and board members will want to have access to.
Gross Burn Rate Calculation: Add Up Total Monthly Operating Expenses
Net burn rate is the total amount of cash you're losing per month.
It factors in your total expenses and total income in a given month. This includes proceeds from revenue and cost of sales. Net burn is the same as net income on your monthly P&L statement.
This type of cash burn rate provides the most comprehensive view of burn by weighing revenue and income against expenses.
Investors and board members prefer this burn rate because it uses accrual accounting. This makes for a more consistent calculation and contextual alignment with the rest of your financial records.
Net Burn Rate Calculation: Total Monthly Revenues – Total Monthly COGS – Total Monthly Operational Expenses
Relationship Between Burn Rate and Startup Runway
Burn rate and startup runway go hand in hand. You can use the burn rate calculation to quickly determine your company's cash runway (how long your company can operate at its current rate before running out of cash).
How to calculate startup runway using net burn rate
Use your average net burn rate and current cash balance to determine how many months your company can continue operating before running out of cash.
Startup Runway Calculation: Cash Balance In Current Month / Average Net Burn Rate
Using Cash Burn Analysis To Make Financial Decisions
You’ll typically want a negative cash burn rate because it means you’re accumulating cash instead of depleting it. But there are scenarios where investing money aggressively in growth makes sense.
Regardless, keep a close eye on your cash flow statements, plan for your expected burn rate, and monitor your progress.
The following three tips will help you use cash burn rate to make more effective business decisions:
1. Determine If Your Products Or Services Are Profitable
Your cash burn rate can tell you how much revenue your business needs to earn to start producing profit as quickly as possible. Because you typically calculate burn rate monthly, you can also get a granular view of whether your products or services are profitable.
With that knowledge, your management team can make quick, agile decisions that bring your offerings to profitability faster.
Additionally, profitability, or the value of a company, is a critical determiner in getting business loans. Carefully managing your startup cash burn is essential to achieving profitability as quickly as possible — and maintaining it.
2. Adjust Spending
If your cash burn rate analysis reveals a high monthly burn rate, consider looking at actions to reduce your costs and cash burn rate.
Some ideas include:
- Reevaluating your software tools recurring expenses
- Reducing personnel expenses
- Selling assets
- Increasing sales
- Investing in product enhancements or research and development
3. Identify New Areas Of Opportunity
You can find areas of opportunity for profitability by using your cash burn analysis. For example, automation and artificial intelligence (AI) are helpful tools for reducing labor costs and increasing efficiency, especially in administrative, HR, and financial areas.
Another revenue-enhancement strategy is exploring new markets or products and services. If your analysis reveals a highly profitable offering you’ve already optimized, it may be time to offer it to new customers or markets.
Or you can take that offering and create tailored versions that increase upsells and customer retention.
Additionally, you can use cash burn analysis to see where most of your costs are. Are they aligned with industry trends and new technological developments?
If not, you may spend too much of your resources on outdated technology and trends that drive inefficient results.
By using your cash burn analysis to identify improvements in cost efficiency, revenue, and competitiveness in the industry, you can reduce your burn rate and gain profitability faster.
What Makes Cash Burn Rate So Important For Startups?
Calculating cash burn rate is crucial for established companies and startups. It assists in forecasting future investments and identifies minimum income or loan amounts required to offset expenses.
Investors refer to this ratio to ensure they understand how much cash they need to provide to help the company meet its costs.
Get Automated Calculations Of Your Startup’s Crucial Financial Metrics
It’s crucial to understand and calculate your company’s cash burn rate since it can determine whether or not you’ll be able to sustain your operations.
The cash burn rate formula calculates how quickly your company spends its cash reserves in a specific period. If your monthly cash burn rate is high, you’ll typically want to reduce your costs and burn rate quickly.
Increasing operational efficiency is one of the most effective ways to lower the burn rate. A lean financial operations team that uses AI to deliver automated, real-time financial statements and calculations can be invaluable in helping you do that.