Last Updated: December 2024
In today’s fast-paced business landscape, understanding what is a burn rate in business is crucial, especially when 70% of startups run out of cash within their first 20 months. Burn rate is the pace at which a company spends its capital. It can reveal much about a business’s sustainability and growth trajectory.
Whether you’re a startup seeking investment or an established business managing cash flow, tracking and optimizing burn rate can mean the difference between thriving and just surviving. In this article, we’ll explore what is a burn rate in business and how to calculate, analyze, and strategize around your business’s burn rate.
What is a Burn Rate in Business?
Burn rate is the rate at which a company is spending and consuming its cash reserves to cover expenses. Basically, it is a measure of how fast a company is “burning” the money it has in its bank to keep the lights on, pay salaries, or expand. Burn rate is typically stated in monthly-term expenses.
Gross Burn Vs Net Burn
The two types of burn rates are gross burn rate and net burn rate.
Gross burn rate is the total cash used every month. It is useful to see how much you are spending altogether and how frequently. This is all about how much these big purchases are costing your budget based on time; for example by month or quarter.
Net burn rate is money in minus money out. This is a particularly useful metric to understand, as it tells you how much cash you are really burning compared to your revenue coming in. This helps you know whether you are on the way to growing or sinking in a cash flow challenge.
While both approaches are essential for measuring financial health and sustainability, net burn rate is arguably more critical than gross burn rate.
What is The Formula for Determining Burn Rate
The burn rate formula calculates how much cash a company is spending over a specific period, typically monthly. Here’s how to calculate it:
Gross Burn Rate
The Gross Burn Rate formula calculates total monthly operating expenses without factoring in any revenue.
Net Burn Rate
The Net Burn Rate formula considers both expenses and revenue, showing how much cash a company is actually “burning” each month.
Burn Rate Vs Run Rate
Both run rate and burn rate are metrics that measure financial performance based on cash at hand, but they measure different things.
Burn rate centers around the cash level and at the same time the cash burn level of a company: It says how long can the business survive before fresh capital is required.
Run rate, on the other hand, uses current financial data in order to project future performance on the assumption that revenue or expenses will remain at the same level for the foreseeable future.
Burn Rate Vs Churn Rate
Burn Rate is the rate of spending capital to show, how aggressively capital is burning away as cash flow from the business. On the other hand, Churn rate monitors the exit rate of customers or subscribers that may affect the stability and growth of the revenue.
A high burn rate can indicate that a company needs to rein in spending or find more sustainable sources of revenue to ensure that it lasts through vital periods. On the other hand, excess churn means the company is facing problems around customer satisfaction, product/market fit, or both. This needs to be addressed quickly to stabilize the customer base and prevent the decline in revenues.
Each metric focuses on a different aspect of financial health and customer retention and both impact the long-term viability of the company.
Why Burn Rate Matters?
The reason burn rate is important is that this metric tells you how long a company can go on spending based on its current income. Also, it highlights the financial health and sustainability of a startup or growing business.
So, Here are a few of the critical reasons that make burn rate so important.
1. Determines Financial Runway
A company uses its burn rate to know how long it can survive with its current cash balance. That “runway” is crucial for planning the likely next funding round for a company, and having planned wellbeing better positioned. For example, if a company has a high burn rate then it has a shorter runway and likely will need to raise capital soon.
2. Helps in Cash Flow Management
Companies can track and manage their cash outflow more efficiently by understanding the burn rate. This will help prevent overspending, and maximize the usage of funds. Monitoring burn rate regularly can also reveal opportunities for expense reductions to enhance financial safety.
3. Affects Investor Confidence
The burn rate of a company is closely watched by investors as it reflects the discipline in spending and sustainability. Indeed, a sustainable burn rate will be a massive plus for a business attracting investors. Companies with a high burn rate but no signs of progress or success are seen as wasting resources and are therefore more likely to fail.
4. Guides Growth and Expansion Decisions
Understanding the burn rate enables a company to reasonably plan for growth initiatives without exceeding its financial resources. So, hiring, product development, or market expansion can be counterweighted by the cash outflow to prevent over-stretching resources.
5. Enables Crisis Preparation
During an economic downturn or period of revenue slowdown, burn rate allows companies to quickly see how long their existing reserves can last. When the burn rate is sustainable, it can give room to pivot flexibly, realign or bring in emergency funds. It helps businesses survive through economic crisis.
6. Supports Budgeting and Forecasting
Tracking burn is a crucial part of proper financial planning and projecting. Knowing the monthly cash burn allows companies to be more accurate in their budgeting and anticipate future funding needs.
What is a Good Burn Rate?
Defining a “good” burn rate is difficult, as there isn’t a one-size-fits-all answer. A good burn rate typically allows your company to grow at a healthy pace over time.
Some sectors inherently attract a higher rate of burn than others. Of course, different types of businesses have different capital needs, and some, such as hospitality or eCommerce, have large overhead expense requirements. That means their burn rates will be higher than those of others, such as a fully remote digital agency.
As long as the cash flow is positive, the business can deal with the unexpected expenses and it leaves some space to grow. Hence, its finances are not in a bad place.Thoug, regardless of the situation, it is advised for any business to maintain a burn rate that ensures at least six months of cash runway.
Average Burn Rate for Startups
According to a Scale Venture Partners study the natural monthly burn rate for early-stage startups is approximately $50,000. It also varies by a multitude of factors:
- Startup Stage: Burn rates for early-stage startups tend to be higher than later-stage startups. Their expenses are mainly driven by product development and growth, both of which are capital-intensive activities.
- Industry: Your burn rate also depends on the industry you are operating in. For example, technology is a capital-intensive industry with a higher burn as compared to something like retail.
- Location: Burn rates can differ from place to place as office space, salaries, and other costs play an important role in capital requirements. For instance, San Francisco or New York City demands a higher burn rate than a lower-cost area.
Although having a larger cash burn is expected and often needed to fuel later-stage growth. It is also crucial to dial down burn over time to reach profitability and longer-term sustainability.
Benchmarking your burn rate to analogous revenue-size startups in your vertical can be a useful clarity tool to understand whether your financial picture is healthy or if you need to make adjustments.
How to Reduce Burn Rate?
Cutting costs to keep the company running longer is the most impactful strategy for maximizing the runway and minimizing the burn rate. Some of the popular practices for doing so include:
Reduce Churn-rate
No matter if your underlying monthly overhead stays constant, a high customer churn rate will affect your revenue and increase your burn. It is important to control the churn rate. A high rate of churn can kill your business.
Cut off Products That Don’t Sell
Most companies prefer to have more product varieties, even if some products fall flat. Not every product is worth retaining as the business could probably do with a little pruning, Sometimes even a pause or discontinuation on the worst performers.
Cost-effective Marketing
While many startups depend on marketing for growth, they are rarely in a position to invest largely in paid advertising. Instead, they should rely on “growth hacking”; low-cost, novel methods for rapidly increasing their user bases.
For example, the engineers at Airbnb creatively leveraged the customers of Craigslist to send traffic to Airbnb’s own site, building their platform at little to no marketing cost.
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Conclusion
In conclusion, understanding what is a burn rate in business and managing it efficiently is crucial for sustainable growth and long-term success. According to recent research, nearly 45% of startups are failing, within 5 years of their incorporation, the reason often tied to an uncontrolled burn rate.
Keeping a close eye on the burn rate not only helps with budgeting but also gives business owners insight into how much time they have to reach profitability or secure further funding.
Platforms like Saufter can aid in improving efficiency by automating customer interactions, potentially reducing costs associated with customer support. Leveraging such tools enables companies to better control spending and maximize resources, enhancing financial sustainability for long-term success.
