Are you a startup enthusiast?
Do you want to strengthen your financial fundamentals before making business decisions?
Consider this article as a companion in your startup business as you learn the financial aspects that might help you in your journey.
Let's dive into the terminologies first.
The burn rate is the tool that startups and financiers use to monitor the amount of monthly capital a company spends before making its revenues.
Business runway refers to the time a company has before it runs out of money and whether or not it needs to raise additional funds.
As you know, the burn rate is the cash used up by companies every month. It is a parameter that startup businesses and venture-funded businesses can adopt to determine the negative cash flow. The formula is as follows.
Burn Rate_ = (Initial Fund Balance – Ending Fund Balance) / _Number of Months
There are two forms of burn rate you need to understand:
- Gross Burn Rate - This is the total expenditure that you make in a month. The expenditure can include buying materials for business requirements, salaries, rent, and taxes. It does not take any revenue into account.
- Net Burn Rate - This considers your revenue towards the expenditure. You need to subtract the income and calculate the burn rate on expenditure.
Consider an example where you have spent $10,000 on rent, $10,000 on material, $30,000 on salaries, and earned a revenue of $ 20,000 in April 2021.
The Gross Burn Rate for April 2021 will be equal to $10,000 + $10,000 + $30,000, that is, $50,000.
The Net Burn Rate for April 2021 will be equal to $10,000 + $10,000 + $30,000 - $20,000, that is, $30,000.
In this calculation, consider the difference in cash flow between various months. The cash flow will include the money received from Venture Capitalists (VC) or investors. This is required when you are dependent on VCs.
The formula for the rate calculator will be:
Burn Rate = Fund balance in the previous month – Fund balance in the current month
As a startup founder, you will be curious to know your burn rate irrespective of investor funding or venture funding. It could be a step towards self-sustaining your business. For this, you need to subtract the funding amount for your calculation.
The formula for the rate calculator will be:
Burn Rate = (Fund balance in the previous month – VC fund) – (Fund balance in the current month – VC fund)
Imagine yourself as an aspiring designer, and you require an investor to fund you after you initiate your business model. Once your product launches and gains popularity in the market, you need to assess your business' self-sustainability.
- Zero Burn Rate - After applying the formula above, if the burn rate comes to zero, it implies you are spending as much as you are earning. This puts you in a no-profit, no-loss zone.
- Negative Burn Rate - After applying the formula above, if the burn rate falls in the negative, it implies you are making more money than you are spending. This means that your business is making profits.
Calculation of burn rate over some time (or months) will generate the average burn rate. This is an accurate model of measuring the burn rate because it is dependent on data over a period.
Let us understand this better with the example of an interior design business:
Expenditure in the month of February 2021 = $40,000
Expenditure in the month of March 2021 = $100,000
Expenditure in the month of April 2021 = $100,000
The burn rate calculation per month will give an unrealistic view of cash flow as it increases in the subsequent months with more decoratives to buy and install. So, it is better to calculate the average burn rates over the past few months.
You may formulate a Burn Rate Chart to obtain accurate results.
As you have understood, the startup runway is the number of months left before you run out of funds, and this can be co-related to the burn rate.
The cash burn rate gives you the expenditure per month, and by following that trend, you can gauge how many months your funds will last. A simple extrapolation will generate your results.
Suppose you want to start up a restaurant. Until the day of the inauguration, you have spent 70% of your money over six months. Now you will have to assess how long you can sustain the remaining 30% of your money before you start generating profits.
To obtain an accurate report for your company, it is better to consider the average burn rate. You can divide the balance fund with the average burn rate to get the desired runway value. The result will give you the number of months left before you run out of cash, assuming that your expenses are consistent and you have no investor.
The formula for calculating business runway will be:
Runway (number of months) = Balance Fund / Average Burn Rate
Consider a scenario where you run an event management company as your startup venture. You formed a team of enthusiastic people and organized six different events across the country over six months. Your expenditures included buying gadgets, travel tickets, salaries, and taxes.
Your average burn rate is $25,000, and now you have $75,000 left with you. Clearly, by applying the above formula, your business can sustain itself for three months without additional funding.
Analyzing the burn rate and the runway is your primary task as a business holder. However, you need to evaluate whether you can prolong your business or if need additional funding from investors.
Consider two different cases here:
- Case 1 - You are an aspiring singer and aim to release your album in two months. You have spent $5,000 on recording and studio charges. You have a balance of $1000, and you need $2,000 as marketing charges. Your album won’t release until two months, so there is no additional source of income.
In such a scenario, you cannot sustain your business without external funding.
- Case 2 - You started an architecture firm, and until today your average burn rate has been $25,000. Your next payment is due in three months, and you have a balance of $100,000. So by this data, you can sustain your business for three months as your runway is four months (assuming your expenditure is consistent).
Therefore, the burn rate and runway can differ depending on the business' position at a certain point.
Analyze your burn rate calculation and make a decision. If your burn rate is higher than your contemporaries, you need to find ways to minimize it. Unnecessary expenditures can impact your burn rate. A good idea would be to sell or unsubscribe to software and tools that are lying idle.
On the other hand, if your expenditures include engaging talented professionals who can help you reap benefits in the long run, do not consider eliminating them. Eventually, you are the decision-maker, so you must be reasonable and realistic in your approach.
You must refrain from making hasty decisions that could negatively impact your business.
Improving Burn Rate Metric is better than reducing it. Here are few ways to enhance burn rate:
- Analyze your financial reports and figure out ways to mitigate losses.
- Reduce unnecessary costs and overhead charges.
- Consider selling assets that are not required.
- Increase revenue and look at long-term benefits.
Irrespective of market or business conditions, burn rate and runway are essential tools. You need to keep all options open and be agile in executing your business plans. In the case of a startup, these tools are critical, as you need to analyze your funds at every step.
The above-mentioned cash calculator and calculation techniques can help you make robust decisions. They help you understand the status of your business' financial health. The burn rate and business runway will help in securing investments from VCs.
Diagrammatic representations involving burn rate charts can post a clear picture of your startup to the investors. These calculations will also be helpful for any future reference or training.
When you are a creative person and want to dedicate more time to innovation and product design, you should find companions to do your bookkeeping. A seasoned bookkeeper or financial consultant will give you accurate financial reports on time.
An efficient, creative-focused bookkeeper like Fincent can cater to a wide range of startup businesses like designers, developers, event management companies, freelancers, artists, independent consultants, musicians, and more.