Success in business is determined by profitability (aka cash is king). Every metric used to measure results is ultimately connected to the one number that truly matters: profit. If your cash flow is positive, your business is making a profit. When you’re burning cash, your team needs to find a path into the black. That’s typically done by cutting costs or boosting revenue (usually by increasing pricing). Neither of which are especially attractive options.
Most burn rate resources focus on downsizing as a way to become cash flow positive. But reducing the size of your workforce or lowering wages are not the only strategies to achieve this. For example, proactively managing spending with tools that provide real-time visibility can help businesses avoid reactive measures like layoffs or pay cuts.
Topics included in this article:
- What is burn rate?
- Why is knowing your burn rate important?
- How to calculate your burn rate
- Burn rate example
- Five ways to reduce your burn rate
- Burn rate limitations
- A tool that can help you lower burn rate: Ramp
What is burn rate?
Let’s be honest: startup companies rarely have positive cash flow during their early stage. They self-fund or seek venture capital, develop a product or service, and then build a sales pipeline. Revenue comes last. A solid base of initial funding increases the runway to build, but at some point any new company must create cash flow to sustain itself.
Burn rate is a measure of negative cash flow. Prior to creating a revenue stream, it’s the rate at which a business is “burning” their venture capital. An example of this is the development costs of building an online platform. The business isn’t generating any revenue while the engineers are coding. The business is spending the amount of cash they have at a certain pace, and the pace of that spending is the burn rate.
Beginning to generate revenue doesn’t eliminate the company's burn rate. To achieve profitability, a business needs to bring in more than they’re spending. That’s known as “cash flow positive.” Until you reach that point, you’re still burning some amount of money, albeit at a slower pace as revenues increase. This is a critical metric to track for all businesses, not just startups.
Why is knowing your burn rate important?
Tracking your burn rate should be part of the financial planning and analysis of your company. It’s not a line item on your financial reports, but it can be calculated using the cash flow statements from those reports. We’ll explain in further detail below.
The need for positive cash flow should be obvious, but many venture funded businesses wait too long to create revenue streams to eliminate burn rate.
Entrepreneurs sometimes assume that they can simply do an additional round of funding to cover new costs if they’re making progress on the development side. This is a mistake for several reasons:
- Funding could dry up: Venture capitalists have other prospects. During fundraising, you’re going to compete with other businesses that are paying attention to their financial statements, current cash flow, and burn rate, and can prove their ability to be profitable. Keeping your own burn rate low increases your chances of getting additional funding if you need it.
- Acquisition is unlikely: Burn rate is one of the metrics that potential acquirers will look at when evaluating an acquisition target. If your goal is to exit via sale, your burn rate is part of the equation. Not knowing it shows an inability to manage cash flow and it could potentially show that you are overspending and have no cash reserves.
- Sustainability is not proven: Businesses that burn cash at a steady rate and never prove they can be profitable are not sustainable. As a startup, you’ll want to be as lean as possible. Track your burn rate so you’ll know if your business concept works.
- Shorter development runways: Successful businesses constantly develop and improve their product. This is true when breaking into an existing market or introducing something new. Low burn rates can give you a longer development runway.
How to calculate your burn rate
There are two different types of burn rates. The first, known as gross burn rate (or monthly burn rate), is the total of operating expenses incurred by the business each month. The other type is called the net cash burn rate. That’s your total revenue minus your total expenses. If that number is negative, you’re burning cash. If it’s positive, you’re cash flow positive.
One of the easiest ways to calculate burn rate is with your cash flow statements. Subtract the ending cash balance from the starting balance and divide by a specific time period, i.e., the number of months. For instance, if you’re using a cash flow statement from your quarterly report, the burn rate calculation formula looks like this:
Burn Rate = (Starting Balance – Ending Balance) ÷ 3
If you’re between statements and want to look at your burn rate for the month, add up your expenses using bank and credit card statements. Revenue numbers should be registered in your accounting software. If you don’t have software set up yet, use your bank statement to count deposits. Exclude any inflows that come from venture investments.
Burn rate example
A simple example of this is your standard SaaS company. Let’s say you pay $5,000 a month for office space, $10,000 for monthly server costs, and $15,000 for wages. That’s $30,000 in total expenses. Assume your monthly revenue is $30,000. That’s a net burn rate of zero, so you’re in good shape. Here’s what the formula looks like:
Burn Rate = ($5,000 + $10,000 + $15,000) - $30,000 = $0
Take those same numbers and apply them to an online store. This adds the additional element of cost of goods sold (COGS), which is the cost of manufacturing the products you sell. Use the same numbers, but then add in a COGS of $10,000. Your numbers now look like this:
Burn Rate = ($5,000 + $10,000 + $15,000 + $10,000) - $30,000 = $10,000
With the cost of goods sold, you’re now burning $10,000 a month. These examples emphasize the importance of including all costs and expenses when calculating your burn rate. In the scenario of the online store, missing the COGS could seriously skew the numbers. You’d be operating at a loss and not know it. That’s a recipe for failure.
Five ways to reduce your burn rate
Laying off employees or reducing salaries are knee-jerk reactions to high burn rates. Neither produces a long-term benefit. Layoffs signal that your company is on a downtrend. Lower pay rates attract less qualified prospects. There are ways to cut your expenses that won’t hurt your reputation or disrupt someone’s livelihood. Try these instead:
1. Get real-time spend visibility
Cutting expenses and reducing operational costs is much simpler when you have real-time visibility into your spend. Tracking business expenses as they happen can let you know exactly how much you're spending each month. Visibility can also help you reduce expenses by identifying issues like duplicate spends.
2. Increase employee efficiency
Startups with expanding teams often have inefficiencies that don’t get uncovered until much later, when the business is fully established. Examples of these inefficiencies include making employees file expense reports, closing your books, and rolling out benefits. Identifying those inefficiencies early and correcting them can reduce costs, thus decreasing your burn rate. Solutions in this category include retraining, upgrading systems and processes, and forming teams where necessary.
3. Streamline your expense approval process
Streamlining the expense approval process puts you in control of your outflows. Combine this with real-time visibility functionality and your accounts payable department will have a better system for controlling costs. It also helps to train employees on which expenses will be approved and which won’t.
4. Upgrade your tech stack
Sometimes the best way to save money is to spend in order to upgrade your tech stack. Do your homework because newer doesn’t always mean better. Look for applications and financial management software that integrates with other apps for automated data flow. Eliminating manual processes with automation is an efficient and painless way to cut your costs.
5. Automate your expense reports
Tracking expenses, organizing receipts, and compiling expense reports are all tedious jobs that waste your employees’ time. Expense automation and automated reports can save your employees hundreds of hours each month, time that can be spent on more productive work that will actually move the needle.
Burn rate limitations
While a burn rate can help you understand how much money a company is using, it can’t tell you whether the rate is sensible or disastrous.
Determining that is an internal process. In some cases, burn rates are not necessarily a bad thing. The spending can show that you’re dedicated to the development and growth of your company.
Getting to the point where you’re cash flow positive is a milestone, but most companies increase their spending at that point, settling for a manageable burn rate in exchange for additional growth or product development. That’s a good burn rate. It’s predetermined by the company, not the result of escalating and uncontrollable costs in the startup phase.
A tool that can help you lower your burn rate: Ramp
A bad burn rate results in costs going up and revenue coming down. Identifying the underlying problem will take more than simply knowing what your burn rate is. You’ll need a cost analysis and revenue statements. You also need the right burn rate management tools.
Enter Ramp: the spend management platform that can help you control your burn rate. With Ramp, you’ll have access to real-time insights, controls to help you manage your spend, and streamlined integrations.
Visit Ramp today to see how our cards and software can help you stay in control of your spend and increase the lifespan of your startup.