Burn rate is a measurement of how fast your business is spending its cash reserves. You measure burn rate when your company has negative cash flows—when it’s spending more than it earns.
It’s essential to track burn rate if your business is losing money, so you know how much longer you can keep operating without a profit, and plan how to grow your revenue in the future.
Who needs to worry about burn rate?
Burn rate (or cash burn rate) is a critical metric to three types of businesses:
1. Startups with venture capital funding
A startup typically goes into business with funding from investors, often venture capitalists. The startup spends the invested cash to develop and market its product. They may go years operating at a loss before either succeeding (making a profit) or running out of money.
By measuring their company’s burn rate, startup business owners can plan the number of months they’re able to operate at a loss before they need to start earning a profit. The period of time until cash reserves are emptied is referred to as a “cash runway.”
Burn rate is also important to startups looking for funding that don’t have investors yet. When fundraising, they present financial projections explaining how much venture capital they need to develop their product, when they expect to start earning a profit (and how much), and what their burn rate will be.
2. New companies getting on their feet
Some businesses start with zero customers. For instance, you may launch a killer website for your online Western wear store and start advertising on social media. But until customers actually start making purchases, you’re spending money on ads and web hosting but not earning any to pay for it.
In this example, you need to project a reasonable burn rate for your business. How many months of cash do you have to keep your store open, assuming you don’t make a profit? This number depends on your operating costs and the amount of money you have invested from the start.
Your burn rate is the metric that tells you how long you have to start making a profit and what to do until then—for instance, whether you should spend more on advertising or more on diversifying your inventory for additional revenue streams.
3. Older businesses borrowing money in tough times
Even well-established businesses falter; fads change, and suddenly your fidget spinner emporium isn’t making a profit. In that case, you may use a small business loan or a line of credit to keep the lights on while you build new strategies to start breaking even again.
When you need to make a big change like this, you’re operating a lot like a new business. You need to know how long you have to develop and test ways to increase revenue before the bank’s money runs out. You also need to budget for interest payments once you do start making a profit again.
Gross burn rate vs. net burn rate
Just like there are two ways of measuring profits, there are two types of burn rate: gross and net.
Gross burn rate measures your monthly operating expenses without taking revenue into account. Net burn rate, on the other hand, tells you how much money you’re spending per month, but includes revenue in the equation.
Gross burn rate is helpful if you’re focused on measuring operating expenses—for instance, if you’re looking for ways to cut back spending in your company. Net burn rate is useful if you want to measure profit growth since it shows how much you’ve earned versus how much you’ve spent.
How to calculate gross burn rate
The gross burn rate calculation requires two values: your monthly operating expenses and starting capital or total cash.
Monthly operating expenses include everything you spend to keep your business running—rent, utilities, wages, and the rest. Starting capital is the cash balance you first invested in your business—either out of your own pocket, borrowed, or from outside investors. Or, use your total cash at a point in time to find a burn rate over a specific period of time.
For example, let’s say your Western wear store spends $3,500 per month in operating costs, and you’ve funded your business with a $50,000 loan.
$3,500 / $50,000 = 0.07
Multiply by 100, and we get 7%. So, your monthly burn rate is 7%. Every month in business, you spent 7% of your initial investment.
How to calculate net burn rate
The net burn rate calculation requires three values: your monthly revenue, monthly operating expenses, and starting capital or total cash.
In this case, you divide your operating income (revenue minus operating expenses) by the amount of cash initially invested in the business. Alternatively, you can use your total cash at any point in time when looking for your burn rate over a specific period of time.
Let’s say your Western wear store has started earning revenue. You’re still spending $3,500 a month to stay in business, but last month you made $2,000.
Here’s how to calculate your net burn rate:
($2,000 – $3,500) / $50,000
In this case, your operating income is a negative number—you still don’t have a positive cash flow because you’re still spending more than you earn.
–$1,500 / $50,000 = 0.03
Multiply the result by 100, and you get a net burn rate of 3%.
How Bench can help
Bench provides you with the key financial reports your business needs to understand its financial health—including burn rate. Instead of manually counting up revenues and expenses, you have the information you need when you need it. Automated transaction imports and an expert bookkeeper on your side mean you can focus on running your business, not your bookkeeping. If your package includes tax filing, you’ll even have one-on-one access to small business advisors who can help you plan for the future. Learn more.
How to reduce burn rate
A high burn rate is just a fact of life for many early-stage businesses. And you may have already factored a high burn rate into your financial projections. But higher burn rates mean less time for you to start turning a profit. Lowering your burn rate could give your startup company the time it needs to break through.
A few ways you can reduce your burn rate:
Re-evaluate your recurring costs
The sustainability of your business depends on your recurring costs. If your monthly expenses like office space, internet, and web hosting are high, you’ll struggle to cut down your burn rate.
Cut down your owner’s draw
Your owner’s draw is the money you take out of your business to pay yourself. If you’re paying yourself this way, try tightening your waist belt; the less you draw out of your capital accounts each month, the more your business has to work with.
Try bootstrap marketing
If a few accounting cycles have rolled by and you’re still not bringing in customers, try switching marketing strategies. Bootstrap marketing uses minimal resources, minimizing expenditures by using tools like active social media and one-on-one outreach. See what cutting the marketing budget and changing tactics does for a month or two. You may get better results by spending less.
Have a grand opening sale
When you want to turn a profit ASAP, cutting prices may seem counterintuitive. But selling products for less when you just start out—or cutting deals for new clients—may be a necessary evil in order to get your first few sales in the door. This is especially true if you’re expecting referrals to drive new business.
Look for additional funding
Remember, burn rate is a percentage. The bigger your capital investment or current cash, the lower your burn rate—even if operating expenses stay the same. If your business is off to a good start but isn’t turning a profit, you may be able to attract investors looking for high-growth opportunities. Selling shares will give you cash to work with and more time to try new strategies to increase revenue.
Further reading: How to Know if Your Business is Financially Healthy