The Burn Rate is a liquidity index that shows the burn rate of a business, i.e. how quickly it consumes cash on hand. The calculation of the burn rate takes into account negative changes in cash flow and, together with the Cash Runway, offers an estimate of the future performance of a given business.
What is the Burn Rate for
The Burn Rate is an important parameter especially for start-ups but can be useful for evaluating any type of business or investment. For start-ups, which usually do not generate profits in the initial phase of their business, the Burn Rate helps to better understand the timing with which a company spends its capital. Generally, for companies of all sizes, this parameter allows investors to better assess the future prospects of a business in order to make more informed decisions.
The Burn Rate, in fact, on the one hand measures a physiological mechanism - the ability to cover one's expenses even when not invoicing - and on the other hand is an index of cash management skills. It is for this reason that investors - both institutional and non-institutional - place particular emphasis on Burn Rate analysis. A low Burn Rate, for example, may indicate a good ability to manage corporate money, and would therefore be an incentive for those who want to invest.
There are two types of Burn Rate: Net Burn Rate and Gross Burn Rate. A company's Gross Burn is the total amount of operating costs it incurs each month for expenses. A company's Net Burn is the total amount of money a company loses each month.
How the burn rate is measured
The Burn Rate is usually stated in terms of the cash spent each month. Suppose, for example, that a company is started with an investment of EUR 100,000 and during the year the same company has a negative cash burn of EUR 46,000. You will have:
Initial cash: 100,000 Euro
Cash variation: -46,000
Ending cash: 54,000
Burn rate = 54,000/12 = 4,500 Euro
A company can reduce its gross burn rate or the total amount of operating costs it has each month by generating revenue or cutting costs.
Difference between Burn Rate and Cash Runway
The Cash Runway is the amount of time a company can survive before accessing further financing. In other words, it is the time remaining until there is zero money left in the till. The Cash Runway is calculated:
Cash Runway = Cash Remaining / Burn Rate
The Burn Rate, therefore, is the main variable for calculating the Cash Runway and has a direct impact on how long a company can survive.
As a rule of thumb, it is good to calculate these ratios (or at least the Burn Rate) monthly. A Burn Rate under control gives investors confidence because it shows awareness and care on the part of the entrepreneur or manager of a company. In fact, the Burn Rate is a kind of compass that allows one to know when to correct course by seeking new investments or lowering costs and thus gives a measure of management's ability to navigate uncertainties.