If you want to know the liquidity of your business, you have to measure your burn rate . This metric is very popular especially among startups looking to manage expenses and improve operational efficiency.
Monitoring Burn Rate is the first step to being the master of your money. With benchmarks to guide us, we’ll get a solid picture of what your Burn Rate should look like.
Let’s learn more about the importance of this metric and how to measure it.
What is Burn Rate?
Burn Rate measures the rate at which your company spends capital to generate revenue. It is usually expressed as Net Burn. Net consumption is mainly composed of gross profit subtracted from operating expenses, such as administrative costs, sales and marketing expenses. This is the formula:
Net burn = Operating expenses – Gross profit
As a reminder, gross profit is calculated as the difference between revenue and cost of goods sold (COGS).
How to calculate the burn rate?
Calculating the burn rate is simple, especially if you have a cash flow statement. The formula is simple:
Burn rate = (Beginning balance – Ending balance) / # Months
Let’s say your company has just obtained 1 million pesos in financing from investors. Congratulations. Now you have the capital you need to make big investments in your business, whether that’s hiring more employees, purchasing expensive equipment, moving offices, or all three.
As you start spending that money, you’ll start to see your cash balances deplete. As a business, you’ll want to be strategic about what to spend money on and when you might look to raise more funds. Therefore, keeping an eye on the burn rate will be essential to ensure that your cash reserve does not reduce too quickly.
Let’s assume that your company already had 200,000 pesos in the bank before receiving financing from investors. This makes your initial cash balance 1.2 million pesos. After three months, you see that your cash balance has dropped to 900,000. According to the formula, your company is losing 100,000 per month.
(1,200,000 – 900,000) / 3 months = 100,000 /month
The key to calculating burn rate is to choose a period long enough to obtain an accurate average. If you calculate it using data from just one or two months, any fluctuations in spending can give you an inaccurate reading on how quickly you are actually spending money.
Using the example above, if your company spent only 50,000 in the first month and 125,000 in each of the following two months, calculating the burn rate only from the first month would give you an unrealistic view of the life of your cash. Therefore, it is important to recalculate the percentage of consumption each month and use a time period long enough to ensure accuracy.
There are also variations on the burn rate calculation that can give additional insight into your expenses.
The Gross Burn shows how much your company spends on operating expenses alone. Operating expenses include things like payroll, rent, and taxes. This metric is based on the assumption that your business is not generating positive cash flow. If the previous business, for example, is spending 40,000 per month on salaries, rent and utilities, the gross burn rate would be 40,000 per month.
Net burn takes into account revenue (if your company has generated any), but still takes into account a single month. To calculate it, simply subtract your income from all expenses and obligations for a month. This will leave you with the amount of money that was lost that month.
Investors can specifically ask for these metrics when deciding whether or not to invest in your business. However, most business owners trying to understand the state of their finances will choose to calculate their overall burn rate.
Importance of measuring burn rate
To grow, emerging companies usually rely on financial support from investors (private funds, business angels, etc.).
When a potential investor is approached by a startup, their first instinct is usually to look at their accounts and observe their cash flow. As an investor, he seeks above all…return on investment. Know if the company you agree to finance will be profitable. A little like real estate loans in banks…
One of the recurring issues in negotiations refers to the burn rate. For them, it is a notion of risk: what we are trying to find out by asking about the burn rate is how long their investment will be enough to meet the needs of the company before actually generating a positive cash flow.
In other words, the lower a startup’s burn rate, the more likely it is to attract investors. This is because they can be sure of making a good profit.
Furthermore, if you have good control of the burn rate index, you will be able to better control the various financial risks associated with companies. You will have enough capital to implement different solutions to sustain the startup.
At first glance, the burn rate tells you the speed at which you are consuming your cash reserves. Too much consumption obviously means you’ll end up running out of cash, which is why it’s so important to regularly track your financial metrics.
What the burn rate really gives you is an indicator of your operational efficiency. How much of your operating expenses are being converted into growth for your business? The funny thing about chasing growth is that startups often overspend to acquire new customers and lose sight of the net spend. Monitoring your burn rate is the first step to controlling your costs and becoming the master of your money.