Running a business involves monitoring different “numbers”. It can be overwhelming to monitor income ratios, daily sales outstanding, and an endless number of financial reports. However, your company’s burn rate is one number you don’t want to ignore.
Your burn rate is one of the most important numbers you can have when you're planning the financial success of your company. It's also one of the most important numbers for attracting new investment funds.
What is the “Burn Rate”?
The “burn rate” is an important number all business owners should learn. The burn rate measures the level of sustainability of your business. What it does is it shows negative cash flow, or how long (usually months) you can stay in business with the fincial liquidity you have. Burn rate is usually used when talking about startups, or businesses that depend heavily on invested funds.
Why Does the Burn Rate Matter?
Although it might be obvious to some entrepreneurs why the burn rate matters, the primary reason is it shows you the amount of time you have before you run out of cash.
Also, investors will often look at a company’s burn rate and compare it to potential revenue to see if it is a solid investment. If the burn rate is higher than it was supposed to be, or if revenues are not growing as quickly as forecasted, then investors may question the investment. The burn rate is an easy way to measure the level of risk associated with investing in a particular company.
How to Calculate Burn Rate
Performing a complete analysis of the burn rate or cash consumption will tell you and your investors whether your company can sustain itself, signifying if you're going to need additional investment or have to cut costs.
For example, let’s say that your company needs $10,000 every month to pay the bills and utilities. However, your sales are only $5,000. This means you are “burning” $5,000 every month or that you are spending more money than what you are making. Depending on whether you are a startup or an established business, your “burn rate” may differ, whether that is a year or three months.
Here are two burn rate formulas to follow:
Burn Rate = Your Total Cash Position/ A Specified Period of Time
Time Before Cash Runs Out = Cash On Hand/Burn Rate
Now that you have a better understanding of what the burn rate is, why it is important for your business, and how to calculate it, here are some ideas to consider when you're trying to improve your burn rate.
Save Your Money. Today businesses wonder where to save their money. Whether they save it in a savings account, money market or the old “under the mattress” method, saving money is crucial to keep your burn rate lower, so get in the habit of saving smarter. Build up a cash reserve, your business will thank you.
Decrease Your DSO. If your business is struggling with sales, then the good news is that there are other ways to find cash in your business. For example, decreasing your Daily Sales Outstanding (DSO) in your accounts receivables can help give a company more cash on hand. This is the amount of time that it takes for your business to collect on accounts receivables, or the money owed to your business for selling or providing goods or services.
If you have a Net 30 payment policy, and it’s taking you an average of 40 days to collect, then it is probably time to revisit your collection policy.
Selling Company Assets. As a startup business, you may not have a ton of assets, but if you are trying to improve your burn rate, and have assets that you can offload, then consider doing so. You may have some assets are costing you too much in upkeep and you are hurting your business’ cash position as a result.
The Bottom Line
It may be difficult for many startup businesses to begin to see sufficient sales or profits in the beginning. Maintaining a good relationship with your investors (and potential investors) is crucial if you're in this boat. Keeping your burn rate low and your expenses low is going to go a long way in attracting more funds.
Another important reason is to keep your employees feeling safe in their jobs. When financial information is passed around, the smart employees can put two and two together. Keeping your burn rate manageable is crucial to keeping those good employees around.
Investors don’t want to get stuck in an unfavorable or difficult financial position because they invested in a company with poor cash flow. If the goal is to grow your business or to attract investors, then pay attention to your burn rate, and keep your business afloat.