What is burn rate and how can I use a burn rate calculator to get a better view of my expenses?
It’s common knowledge that businesses aren’t usually profitable in the first year. Startup owners and small businesses looking to expand typically rely on personal funds, venture capital, and other investments. It’s not always money being invested, either. Some invest expertise in the technical and managerial areas.
In an ideal scenario, these invested resources can help businesses get through those first-year hurdles and become profitable. However, this is a high-risk investment with no guarantee of a good ROI (Return on Investment). So, investors need to weigh the long-term money-making potential of these businesses.
One way to do this is by examining the burn rate of these companies.
What is Burn Rate?
Burn rate is a metric used to track the amount of time it takes before a company that is not currently profitable runs out of money. A business usually measures this by how much cash the company spends monthly.
Why is Burn Rate Important?
Using a burn rate calculator, investors and startups can determine how long a company has before they
- begin generating income and become profitable; or,
- deplete their cash reserves.
From the perspective of a startup, a burn rate can show you your spending habits. A company can look at these monthly numbers and determine whether their company is sustainable if they keep operating under the same conditions. Later on, we will discuss some strategies that could positively affect burn rate.
From the perspective of an investor, the lower the burn rate, the more ideal the investment appears. Even if analysts project that a company is going to run out of funds early, an investor can still fund them. This company may simply need better management or long-term funding plans to lower production costs.
How to Calculate Burn Rate?
Burn Rate Calculator: Burn Rate Formula
There are four important terms to know when discussing burn rate: revenue, gross burn, net burn, runway.
- Revenue – The amount of money that is generated by a business through its operations, such as the sale of a product or the rendering of a service. A business would typically deduct CoGS (Cost of Goods Sold) from revenue before calculating net burn.
- Gross Burn – This is the monthly operational costs or expenses incurred. These expenses include utilities, rent, wages and salaries, equipment costs, maintenance costs, insurance, taxes, interest, and more.
- Net Burn -This is the total amount of money spent by a company in a month accounting for revenue generated by sales.
Since gross burn is just monthly operational costs, the formula is simply adding up all expenses together.
Revenue works the same way, except that you add all the sales-generated funds together.
Now that we know those two, our net burn formula is as follows:
[REVENUE (monthly) – CoGS] – GROSS BURN (monthly operational expenses) = NET BURN
If you’re familiar with double-entry accounting, you’ll notice that net burn and net profit operate similarly.
Their values should be equal on your profit and loss statement.
Burn Rate Calculator: Implied Runway Formula
Cash Runway is the fourth important term. This refers to the amount of time (in months) that a company has before cash reserves deplete.
Runway Formula: STARTING CAPITAL / MONTHLY OPERATIONAL COSTS or GROSS BURN
Burn Rate Calculation Examples
1. Total Cash Balance Calculation Example
Cash balance refers to the money you have in your account. To calculate your cash balance, you need to first know your balance at the start of a period. Then you add the balance to the difference between your cash inflows (investments and revenue) and cash outflows (expenses and payments).
For example, say you have $15,000 in the bank reserved for the business. Now, you have a revenue of $3,000 for the past month. You spent $3,000 on rent and utilities, $500 on wages, $500 on CoGS, and $2,000 on other expenses that month. The Cash Balance calculation would be:
$1,000 + [($15,000 + $3,000) – ($3,000+$500+$500+$2,000)] = $13,000
2. Gross Burn Rate Calculation Example
Using the above example, your operational expenses for the month totaled $5,500.
Note: Some include CoGS in calculating Gross Burn, but for this article, we will separate the two.
3. Net Burn Rate Calculation Example
Monthly Revenue = $3,000
CoGS = $500
Gross Burn = $5,500
Using our net burn formula above, our burn rate calculator gives us:
($3,000 – $500) – $5,500 = -$3,000 net burn rate.
4. Implied Cash Runway Analysis
If we take our starting capital or cash balance and divide it by both our gross burn and net burn, we get the following.
Runway for Gross Burn: $15,000/$5,500 = 2.7 months
Runway for Net Burn: $15,000/$3,000 = 5 months
How to Interpret Burn Rate?
Using the above example, if we have a starting capital of $15,000 and a net burn rate of $3,000, we will eat through our reserves in 5 months.
Anything below 6 months is considered to be a high burn rate.
A high burn rate indicates that a company is spending too much money too fast and could enter a state of financial distress. How can this be remedied? Well, it’s worth noting that in most cases, a company may need to spend more money in the short term to fix a potential long-term problem.
A low burn rate can be a rate that lasts over 12 months. While getting this result from a burn rate calculator may sound like a dream, really low burn rates can also be a bad sign.
An Illustration
One of my favorite stories illustrates this pretty well. It’s called “The Parable of the Talents”.
Before a master was to leave for a time, he entrusted his gold to three servants. To one, he gave 50 pounds of it. To another, he gave 20 pounds. The third servant got 10 pounds. When the master returned, two of the three servants had doubled the gold he gave them. When they turned it over to him, the master called the two fruitful servants good and faithful. He then gave them charge over more of his possessions.
However, the one who had 10 pounds of gold returned the same amount. Instead of investing it, he had buried it in the ground because he was afraid he would lose what he had. The master was very displeased. He called the fearful servant wicked and lazy. Then he commanded him to give his share of gold to the servant who returned 100 pounds of gold.
The Lesson
A burn rate that is too low may signal poor utilization of investment funds. A company may not have used the funds wisely or made no efforts to improve the running of the business. Remember, the investment is already a risk. If you are afraid to take risks when you already have the investment money, you are in no better place than you were prior. It’s just a slower death, a “burying in the soil”.
Not all attempts to improve profitability work. That’s just the way it is with business sometimes. However, that doesn’t mean you don’t try to take calculated business risks through advertising and marketing, new product launches, or testing out different companies to handle manufacturing. A reasonable risk is better than sitting on your hands all day waiting for the “master” to return.
Three Ways to Improve your Burn Rate
Expense Tracking
A company can invest time and some resources looking for places they can reduce expenses. One way to keep a close eye on this is by hiring a bookkeeper or investing in expense-tracking software. They can show you patterns in your spending that may be problematic and need optimization. For instance, if rent and utilities are too expensive, you can consider moving operations to a different building.
Worker Restructuring
You may decide to outsource a lot of the tasks instead of hiring in-house personnel. One of the benefits of eCommerce outsourcing is cost-effectiveness. You don’t have to pay for employee benefits or other overhead costs. You may even consider going completely remote if possible. Sometimes there are also clauses in place that allow for layoffs and pay cuts if a company is experiencing a high burn rate.
More Funding
Sometimes all a business needs is time. This does mean that investors may have to pump more funds into the business until it gets the proper footing. For instance, a business moving to a cheaper place makes no sense if the place they were in previously made them more efficient. There is a lot of risk in investing more funds into a business, but if you believe in what they offer, it may be worth rolling the dice. There are also other ways that investors can lower the risk associated with this type of investment:
- Invest in better management.
- Develop more efficient processes, SOPs, and organizational structures.
- Invest by providing facilities and a workforce.
What Is A Good Cash Burn Rate?
The general rule of thumb for most businesses is to have a runway between 6 to 12 months.
For instance, if you have a capital of $70,000, your monthly expenses for six months should not be $11,667 or lower. For a 12-month runway, you should be looking at $5,833 or less in monthly operating costs.
Tips for Projections
Every business should have a business plan. Part of this business plan should be the amount of money you’re going to need at every stage of the plan. This means making predictions for the types of expenses you expect. Armed with these projections, you can confidently face investors. This also means that you will be more likely to receive the funding that you need. After all, no one is going to give you money if you don’t explain to them clearly what the money is for, and how and when you will get it back to them, plus interest.
When you’re trying to make predictions for your business, we have three simple tips that we like to keep in mind. First, don’t underestimate what you can do in a year or overestimate what you can do in five years. Keep it simple and measurable. Second, break up the expenses into chunks based on the major projects or milestones that you will target during specific periods of time. This helps everyone involved to keep within the budget and stay motivated. Third, don’t forget to attach projections for earnings alongside the expenses. This is so that everyone can see exactly what you predict will be going into and coming out of the business as each milestone is achieved.
Frequently Asked Questions
Why is burn rate important for startups and businesses?
It signals if a company is good at managing expenses and has long-term potential for profitability and growth.
What is the difference between gross burn rate and net burn rate?
Gross burn rate is simply all the costs associated with operating a business.
Net burn rate is the difference between total revenue and total costs.
Is a high burn rate always a bad sign for a startup?
Not necessarily. Since most startups operate at a loss, this is to be expected. However, it could be concerning if these rates remain the same month over month. That could indicate no affirmative action was taken to manage spending, increase profitability, or lower expenses.
What is a sustainable burn rate?
While it varies depending on the business, anything with a 6 to 12-month cash runway is considered healthy.
What Is EcomBalance?
EcomBalance is a monthly bookkeeping service specialized for eCommerce companies selling on Amazon, Shopify, Ebay, Etsy, WooCommerce, & other eCommerce channels.
We take monthly bookkeeping off your plate and deliver you your financial statements by the 15th or 20th of each month.
You’ll have your Profit and Loss Statement, Balance Sheet, and Cash Flow Statement ready for analysis each month so you and your business partners can make better business decisions.
Interested in learning more? Schedule a call with our CEO, Nathan Hirsch.
And here’s some free resources:
- Monthly Finance Meeting Agenda
- 9 Steps to Master Your Ecommerce Bookkeeping Checklist
- The Ultimate Guide on Finding an Ecommerce Virtual Bookkeeping Service
- What Is a Profit and Loss Statement?
- How to Read & Interpret a Cash Flow Statement
- How to Read a Balance Sheet & Truly Understand It
Conclusion
This burn rate calculator combined with the other information we’ve provided will help get you on track to better financial management. If you’re looking for funding, it’s a good idea to get a grasp on these rates and get them to manageable levels.
