The rate at which your cash holding is depleting is termed as burn rate. There are two types of burn rates:
Gross Burn Rate: The total amount you spend every month.
Net Burn Rate: The difference between the amount you spend and earned every month.
You have to subtract the earned amount from the spent amount to estimate net burn. So, a negative net burn value will be something good for your business. Measuring the burn rate allows you to figure out how many months your business can sustain (in the case when you are burning more than what you are earning) or its potential to grow ( when your net burn rate is a negative value)
Method to Estimate Burn Rate
Calculating your burn rate is very simple. Let’s see how you can calculate both types of burn rates.
Net Burn Rate
To calculate it, you first need to know the total expenses you are spending as a company in one month. Then you have to estimate the amount you earned in that month. And then you have to subtract the earned amount from the spent to find the burn rate. If it’s a negative value it’s good for your business.
Gross Burn Rate
It is simply calculated by estimating all the expenses of a month. Both burn rates must be estimated on a monthly basis.
Effective Ways to Manage Burn Rate
Knowing your burn rate helps you in predicting your runway. It will tell you after how many months you will not be able to run your business if the same situation continues. In short, it will tell you after how many months you will be broke. The runway is the net amount you have in the bank as a company. The burn rate tells you how many months are left in zero cash day or Doomsday.
Many companies believe keeping an eye on the net burn rate only will be important. They think so because as long as they manage to keep the net burn rate in negative figures, the amount in the bank will keep increasing, and the chances of growth improve. However, you need to consider the gross burn rate for the long-term growth and sustainability of your business.
You may have a reasonable net burn rate after a couple of months of good sales. As a result, you will tend to spend more as a company which ultimately increases your gross burn rate. However, if your sales are suddenly deprived, you will not have a backup system to nullify that impact, and your runway gets compressed quickly.
Managing the burn rate and growing your business at the same time is tough to balance. As soon as you have money in the account, you want to spend it to grow the business. As a result, the burn rate will get wings and fly high.
How Quickly Can You Burn?
As a startup business, your first effort is to always keep a runway of at least a year in the bank. The minimum runway you must have is for at least 6 months. If it’s getting lower than that, then you need to do something to sustain your business longer than 6 months. Looking for funding is the ultimate thing you will do in this regard.
When you start trying to raise funding, all the VCs will first look into your burn rate. They will do so to estimate how you are going to use their investment and for how much time it can sustain your business. For example, if you are spending $200K every month as a company, then there is no point in raising $10 Million. It can sustain your business for at least 4 years. Why do you need such a long runway or are you trying to bring some changes?
Unfortunately, the cash will not stay that long in the bank. According to experts, when you have money, you will spend it in 12 to 18 months. So, you will not be able to stop yourself from spending the money after raising funds.
If the market is good, and you are managing to grow your business 50 to 75 percent every year, then it’s pretty impressive. Keeping a burn rate in such a case is not a problem but a good thing as you are growing your business.
However, if you are not making as much progress as you are spending, you are going to get into a bad phase. The runway will keep running and investors will have no interest in your business. As a result, you quickly move toward Zero Cash Day.
Frequently Asked Questions
What is a good burn rate?
There’s no fixed value to describe it. Any burn rate that can sustain your business and help in gradual growth at the same time is considered as good for your business.
How do you calculate the burn rate?
To estimate the burn rate, you need to calculate all your expenses as a company. That would be the gross burn rate. To find the net burn rate, you will have to subtract the amount you earned from the gross burn rate. All the calculations must be done on a monthly basis.
What is the difference between run rate and burn rate?
Run rate is the financial condition of our whole company for a whole year. On the other burn rate is the amount at which you are spending your cash holdings.