Discovering the burn rate, a key metric in companies
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A startup can fail for many reasons, but one of the most common is running out of cash before reaching profitability. To prevent this, it’s crucial to understand and control the burn rate, one of the most important financial indicators for every entrepreneur.
Controlling this metric not only avoids cash flow problems but also allows for strategic decision-making and makes the business more attractive to investors. Therefore, in today's article, we discuss this essential concept for entrepreneurs.
What is the burn rate?
The burn rate measures the speed at which a company uses up all its cash reserves. In other words, it refers to how long a company can continue operating before running out of money. It’s an especially relevant concept in startups, where it’s common to have negative cash flows in the early stages.
The success of a company doesn’t only depend on the profits it generates, but also on its ability to efficiently manage the money it has available. Therefore, an uncontrolled burn rate can cause a company to close even if it has a great service or product to offer. Analyzing this indicator can allow you to:
- Evaluate your company's operational efficiency.
- Anticipate liquidity problems.
- Plan financing rounds.
- Be attractive to investors.
- Adjust expenses.
How to calculate your company’s burn rate
The burn rate of a company can be calculated in two ways: gross burn rate and net burn rate. Although both offer useful information, the second is usually more representative of reality, so it’s recommended to use it. We explain how to calculate both:
Gross burn rate
It is the total sum of operating expenses over a given period of time, without taking into account the income that has been made. For example, if a company has spent €12,000 in 4 months: 12,000/4=3,000. This means that this company spends €3,000 per month.
Net burn rate
On the other hand, the net burn rate allows for a more complete picture of the situation, as it does take income into account, which is why this formula is more commonly used: (Total expenses - total income) / period of time. Following the previous example, imagining that the company has spent €12,000 and generated €8,000 over 4 months: (€12,000 - €8,000) / 4 = €1,000, which indicates that the company spends €1,000 more than it generates each month.
The burn rate value provides valuable information about a business's situation. A high burn rate means the company is spending much more than it generates, so it's necessary to analyze the causes and assess whether it's an expense related to a growth strategy. On the other hand, a low burn rate means that spending is more controlled and the company manages its resources well.
However, it must be taken into account that an elevated burn rate isn’t always negative. In many cases, it can be due to investments in growth or product development that will generate long-term income.
Ultimately, a burn rate is essential for keeping your company's financial health under control. Furthermore, it is important for securing investment, as investors take great interest in this indicator, as it informs about the company's viability, potential, and risk.
