Understanding your burn rate is crucial for assessing the capital required to remain operational and determine long-term sustainability. Knowing where your company will be a few months from now will be difficult to estimate if you don't know your numbers.
That’s where calculating burn rate comes into play.
We’ll look at key strategies and scenarios for figuring yours out and handling spending, including how much capital you need to have on hand for optimal success.
What Is Burn Rate?
Burn rate is what a company spends before generating a profit. However, established companies may also want to calculate the burn rate to determine how they handle spending, especially during difficult financial periods.
Generally, you calculate burn rate as a monthly amount. However, you can also calculate quarterly or annually to determine how your spending averaged over time.
There are two important types of burn rate to take into consideration.
Net burn rate is the amount your business spends each month: the total spend, including inflow and outflow, that occurs during the named period. Gross burn rate, on the other hand, only looks at expenditures, with no weight given to the funds coming in.
Calculate gross burn rate by adding up your monthly cash expenses. That might include materials, labor, and other expenses, including maintaining your building.
Calculate net burn as:
Monthly Sales - Monthly Expenses = Net Burn Rate
It may look like a math equation now, but it’s better to understand it as a scenario.
Scenario 1: Burn Rate for Quarter 2
Suppose you want to calculate gross burn rate for your company during its second quarter of operations.
In April, you had expenses totaling $150,000. In May, you saw higher expenses, with around $200,000 in costs. June, however, saw lower costs at just $100,000.
Your gross burn rate for Q2 would be $150,000 + $200,000 + $100,000 total, or $450,000. Your monthly gross burn rate, normally used to calculate business burn rate, would be $150,000 for Q2.
On the other hand, suppose you need to know your net burn rate for the same period.
In April, your company might have seen $75,000 in profits. The extra spending in May did not change profits for the month, leading to just $75,000; however, in June, you saw $100,000 to match your extra expenditure early in the quarter.
Your total net burn rate for Q2 would look like this:
(Gross burn rate total) - (Income for the quarter) = Net Burn Rate
($450,000) - ($250,000) = $200,000.
While the company in this scenario is not yet generating a profit or breaking even (even though it did break even in June of that month), it is moving toward more significant gains and, ultimately, potential profitability.
Scenario 2: Burn Rate for Year 2
In the first year of operations, many companies do not expect to generate a profit. Investors are often pleased if they break even. By the second year, however, the company may want to start watching gross burn rate much more carefully.
The following provides an example.
Gross burn rate: January expenditure + February expenditure + March expenditure + April expenditure + May expenditure + June expenditure + July expenditure + August expenditure + September expenditure + October expenditure + November expenditure + December expenditure = $1,285,000.
Monthly burn rate: $1,285,000 / 12 = $107,083.33.
Net burn rate: Gross annual expenditure - Annual profits ($1,335,000) = -50,000, or -4,166.67 per month.
Ultimately, the company described in this scenario has reached a profit for the year in question. However, the net burn rate might show that this company is not yet profitable enough for long-term gain, which may impact investors' decisions about how much to invest for the coming year.
A look at that annual burn rate might also, for example, suggest that the company is not in a position to increase the number of employees without increasing sales. The company might also need to launch additional features or services or reach a new market or reassess their pricing structure to maximize profitability.
How to Estimate Burn Rate and Cash Runway
Cash in your account can depreciate quickly when your company is starting out. You may have a lot of expenses and, in the beginning, relatively little money coming in. Here’s how to estimate burn rate and cash runway.
Estimating Burn Rate
The most effective way to estimate your long-term burn rate is by looking at your current burn rate and dividing it over months. For example, you might use the estimate from Scenario 1 above to determine that your business has an estimated burn rate of $150,000 per month.
Make sure, when estimating burn rate, you have enough to give you an accurate look at how much your business is spending.
Do not use outlier months (including those with either unexpectedly high or unexpectedly low expenditures that are not consistent with the rest of the time).
In addition, make sure that you pay attention to any extra expenses you may have added. For example, if you have recently added an expense that will cost $10,000 per month, you will need to include that in future estimates of your company’s burn rate.
Estimating Cash Runway
Your cash runway determines how long your company can run with the funds you currently have in the bank. Generally, cash runway assumes your company is running without generating additional income. For example, during pandemic shutdowns, many companies had to estimate how well they could keep operating despite generating no income while waiting for shutdowns to end.
Calculate cash runway as:
Current cash balance / Gross monthly burn rate
Suppose that you use the gross monthly burn rate in Scenario 1. You have $1,000,000 in the bank. With that gross burn rate of $150,000 per month, your formula would look like this:
$1,000,000 / $150,000 = 6.67, or approximately 6.5 months your company could run with the cash available.
On the other hand, suppose your business is generating income, but that income has dropped due to a temporary low period or lull in sales. In that case, you should use your company’s net burn rate.
For example, suppose your sales average $50,000 per month, with the same gross burn rate. Your net burn rate would be $100,000, and you could continue operations for 10 months at the current rate.
Established vs. Startup Businesses: What's the Difference?
In the early days of a startup, you can expect a much higher net burn rate than you will in the future. Around 80% of startups will not make it through the first year of operation. A high burn rate in the startup's early days may mean they have less time to generate profit before running out of cash, which can spell disaster.
On the other hand, an established company may have its own set of calculations to perform regarding burn rate. A high burn rate is normal for some periods: transitional moments, slow times in the market, or economic disruption.
Strong brands often have high cash reserves they can draw on if necessary to maintain the company until profits begin to rise again. For an established company, periods with high burn rates may mean reorganizing internally rather than the fear of shutting its doors soon.
Get Approved for Capital for Your Business
During periods of heavy expenses, even for established companies, you may need additional capital to help you get by. Get an estimate from Gynger to see how much capital you can be approved for, increasing your available cash and giving you the peace of mind that your company has the resources it needs to move forward.