Trevor Williams / Getty Images Learn the two different kinds of burn rates, how they’re calculated, and why it matters to both businesses and investors.
What Is Burn Rate?
The burn rate tells companies how much money they’re spending and how quickly they’re spending it. The term is usually used in the context of a new company that’s trying to ramp up its operations and become profitable. The burn rate allows growing companies to set realistic timelines because it tells them exactly how long they have before they run out of money. There are two kinds of burn rates: gross and net. The gross burn rate measures total spending, while the net burn rate is a measure of net cash flow that accounts for revenue. The burn rate is commonly expressed in terms of months, but it doesn’t need to be. When a company is experiencing a cash crisis, that company may need to calculate a weekly burn rate—or even a daily burn rate—to see how long it has to turn its financial situation around. On the other hand, a financially stable company may only need to calculate a quarterly or annual burn rate.
How Do You Calculate Burn Rate?
To calculate the burn rate, you must first choose a time period to measure and express the rate. For this example, let’s assume you want to calculate the monthly burn rate in the past quarter. To measure the net burn rate in this timeframe, subtract your cash balance at the end of the quarter from your cash balance at the beginning of the quarter, then divide that number by three (for each month in the quarter). To measure the gross burn rate for the same period, divide quarterly expenses by three.
Net Burn Rate
Gross Burn Rate
How Burn Rate Works
A most basic analysis of the net burn rate tells you whether your business is self-sustaining or not. If the net burn rate is positive, then you’re spending more money than you’re taking in, and something needs to change. You either need to cut costs or increase revenue. Furthermore, you can compare your burn rate to your total funds to determine how long of a runway you have. If you don’t fix your burn rate before those funds run out, then you will have to either close up shop or find new sources of money, such as acquiring a loan, seeking out venture capital, or launching an initial public offering. Investors also look at a company’s burn rate. They’ll compare the burn rate to the business plan to see if the business has a realistic chance of becoming profitable. After someone has invested in a company, they may continue calculating the burn rate to track the progress of a company. If the burn rate is getting worse, not better, then investors will want to know why the company is moving in the wrong direction.
Limitations of Burn Rate
As the saying goes, “you’ve got to spend money to make money.” Many companies will start out burning more cash than they’re taking in, and depending on the industry, it may be necessary to operate at a loss for some time before turning a profit. However, at a certain point, businesses have to become profitable. The burn rate tells you how much cash the company is burning through, but it doesn’t address whether the burn rate is reasonable. It’s up to each analyst to carefully assess the business plan and determine whether the burn rate is justified or troubling. The burn rate doesn’t breakdown expenses and qualify them individually, either. A business owner might know their burn rate is troubling, but that won’t help them figure out where spending could be cut, how profits could be increased, or where alternate funding could be found.
