What is Burn Rate?
We call Burn Rate the rate at which it spends its raised funds to cover running costs. It is used with new companies and start-ups and is a measure of negative cash flow.
Investors and managers usually state Burn Rate per month, but in crisis times, we can measure it on a weekly or even daily basis.
The metric is used by start-ups and investors to track the monthly cash expenditure amount before the company starts generating positive cash flows.
We also use Burn Rate to calculate the time a company has before it runs out of money, or the runway, as it is known.
How to calculate Burn Rate?
There are two types of Burn Rate that we can calculate, and both are important for different reasons.
- Gross Burn Rate – all monthly costs (cash out);
- Net Burn Rate – net loss for the month (cash in – cash out).
The Gross Burn Rate equals the monthly costs, while the Net Burn Rate is usually equal to Net Income. To calculate the Net Burn Rate, we use the following approach:
Net Burn Rate = Revenue - Cost of Sales - All Monthly Costs
Having the Burn Rate figured in out, we can calculate the Runway for the company:
Runway = Cash in Bank / Net Burn Rate
We need to remember to calculate the Runway with the Net Burn Rate, as it is essential how much actual cash was lost. Considering the generated income (if any) makes the Runway longer, which has implications on how management devises strategies and how much investors are willing to finance.
Why is Burn Rate critical?
Burn Rate is an indicator of whether a start-up business can survive. As it shows us the rate at which operations consume our financing, the metric is a crucial measure of sustainability.
One reason why Burn Rate is so important is that it shows us when the company will run out of money. Investors also use it together with revenue forecasts to decide whether the company is an excellent investment opportunity. If the Burn Rate exceeds forecast or Revenue growth is less than projected, the company might be too risky of an investment.
Start-ups are usually struggling to generate positive net income in the early stages, as they focus on improving their service or product and gaining the necessary customer base. Therefore, they seek stage investors often, and they invest based mostly on the Burn Rate of the business.
A high Burn Rate generally means cash is depleted faster than projected. It represents a higher possibility for the company to experience financial difficulties. Such a Burn Rate may lead to the need for more funds to be provided to start generating revenue, which might push investors to decide on setting more aggressive deadlines.
Profitable companies have a negative Burn Rate, as they bring in more than they’re spending.
Usually, shareholders and management are happy when the company is profitable. Therefore, Net Burn Rate seems more important at first look. However, managing the Gross Burn Rate is more crucialfor the long-term sustainability of the business. It is a hard-to-find balance between the urge to grow and building a viable company. As soon as we get the funding it ignites the desire to spend and operate on a large scale (and with high Burn Rate).
Many investors state that if they are looking to provide funds to a start-up at the inception stage, where there’s no product, the only thing they care about is the Burn Rate.
According to Mark Suste, MP of Upfront Ventures, Burn Rate shows new investors how much leverage we have, meaning how much in a hurry we are, as well as how much cash we need. At the same time, it shows current investors at what rate the business should be fundraising from here on.
We must also be aware of how our Burn Rate splits between Fixed Costs and Variable Costs, as this can be helpful to project how much of a decrease in our market performance the business can handle by Variable Costs reductions alone. If we cannot separate Fixed and Variable Costs reliably, we might look in a model like the Least-Squares Model or others.
Burn Rate varies with the stage the business is in, the industry in which we operate, the applied pricing model, and others. There is no accepted benchmark, but generally, six months of Runway are considered a good position.
The Runway is the time we have until Zero Cash Day or Doomsday. Most start-ups aim to operate with one year of available Runway at any given moment.
It is generally accepted that if the Runway falls below six months, management should either reduce costs significantly or find additional funding.
When we present our company to potential investors, they look at the Burn Rate and the amount of funding we are looking to seed. These two should logically correspond as to provide around a year of Runway. Asking for 1.2 mil euro, when our forecasted Burn Rate is 24 thousand euro makes no sense, as it gives us 4+ years of Runway. Investors will be skeptical about that and expect of us to provide more context.
A problem occurs whenever the growth of the business experiences a stupor and becomes slower than spending, as this will shrink the Runway quite fast. Investors might not be as keen to invest in such enterprises, which may lead to funding problems.
Reducing Burn Rate
If our Burn Rate goes above what we forecasted, or revenue falls below our projections, the usual approach is to reduce Burn Rate. Mostly, managers attempt such reductions with staff layovers.
Other methods we can use to reduce Burn Rate can include generating more revenue early on, cutting operating costs, reducing staff remuneration, looking for cheaper suppliers and production methods, and others.
Upon providing funding, investors might sign deals that stipulate a cut in payroll should the company experience a higher Burn Rate. Managers, on the other hand, might try to forecast for increased activities, which will bring economies of scale, as this can push venture capitalists to lend more money, expecting higher profitability later on.
Start-ups that are promoting a new product or service tend to spend a considerable portion of their funding on marketing campaigns. Reducing such costly marketing and looking into alternative advertising strategies like ‘growth hacking’ can decrease the Burn Rate significantly and take off some strain from the business.
Early on, start-ups usually fund at stages, so it’s essential to have a good forecast of the Runway for each separate step, so the managers know how long they have until more funding has to be secured.
Start-ups sometimes keep their Burn Rate high on purpose. If the market is performing well and they can attract more funding by showing a high Burn Rate and even higher profitability forecasts, such companies can grow more than 50% per year, which can become risky, as, at some point, the business might not be able to support such growth.
Example Burn Rate model
To illustrate how we might present the Burn Rate and Runway in our Reporting Dashboards, let us look at some examples in Excel. As we are a tech start-up and since dark themes are popular nowadays, we went with a dark-themed dashboard as well.
We can start by organizing our inputs – Cash OPEX, Revenue, and Cost of Sales:
We then apply the Gross and Net Burn Rate calculations to the right:
We can then make use of Excel’s shapes to create some excellent looking KPI’s to highlight the performance for the last month:
And to make it more visual, we can also reference the monthly rates over the period with a chart showing the consistency in our Burn Rate:
To see how we did those, don’t forget to download the Excel working file below!
Tracking our Burn Rate is essential for cost management and helps us monitor the financial health of the business, to catch sudden changes that might hurt future operations.
It also helps us operate cleanly as a start-up.
However, managers are often tempted to present various expenses as a one-off, to lower the forecasted Burn Rate. Doing so can result in a misleading Burn Rate and a Runway that turns out to be shorter than expected. Such discrepancies can have significant effects on the capability of the start-up to continue operating as a going concern.
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