With the cash burn rate, companies determine how quickly they use up their cash reserves and how high their expenditures are within a certain period of time. The cash burn rate is therefore an important indicator because it can be used to better plan and control cash flow. Here we show you the different types of cash burn rates, how to calculate them and what the cash burn analysis is useful for.
Cash burn rate: Meaning
The cash burn rate indicates how quickly a company uses up its cash reserves within a certain period of time. It is therefore a measure of negative cash flow.
This ratio is of high importance for both already established companies and start-ups, because it helps to plan future investments and shows how high the income (or loan amounts) must at least be within a period of time in order to compensate for the expenses.
In the case of start-ups, venture capital investors usually finance the cash, as the company has hardly any revenue in the early stages and this is put back into growth completely. To ensure that expenses are covered at all times, investors consult the cash burn rate so that they know how much cash they need to provide to the company so that it can cover its costs.
Cash burn: Formula
There are two types of burn rate: gross burn rate and net burn rate. These two burn rates are usually calculated for one month, so that a company knows its monthly expenses.
The gross burn rate indicates how much cash the company has to raise for all operating expenses each month:
Gross burn rate = Monthly operating expenses
Operating expenses include expenses such as staff salaries, rent and administration costs. The gross burn rate shows how high a company's total monthly costs are.
The net burn rate indicates how high monthly expenses are when income is also taken into account:
Net burn rate = Monthly operating losses = Revenue - Monthly operating expenses
Here, operating expenses are subtracted from revenue and operating losses are obtained. The net burn rate shows how much cash the company needs to keep its operations running.
In connection with the cash burn rate, the key figure cash runway is also important for companies. This indicates how long the available cash will last if the company continues to lose money at a certain burn rate:
Cash runway (gross) = Total cash / Gross burn rate Cash runway (net) = Total cash / Net burn rate
Example: How to calculate cash burn from balance sheet
A company has a cash stock of £500,000. Its monthly operating expenses are £50,000 and its monthly revenue is £60,000. We now calculate the various burn rates and cash runway:
Gross burn rate = £50,000 Net burn rate = £60,000 - £50,000 = £10,000 Cash runway (gross) = £500,000 / £50,000 = 10 months Cash runway (net) = £500,000 / £10,000 = 50 months
Since the company in this example already has high revenues, the gross burn rate and net burn rate as well as the respective runways differ greatly from each other.
If revenues were to decline - in the worst case to 0 - the company would have a cash reserve for 10 months to cover its running costs.
Cash burn analysis: Why it is important
As we have seen from the example above, by calculating the burn rate and the cash runway, a company can determine how long its cash reserves will last and how high its expenses will be within a certain period of time.
These ratios are therefore very important for cash flow planning because they allow the company to make estimates for future expenditures. This allows it to better plan investments and actively manage its cash flow to avoid cash shortages.
The monthly gross burn rate also provides insights into the driving cost factors of the company. If this is very high, it can be a reason for those responsible to take a closer look at the cost structure and explore possibilities of how costs can be lowered and thus the gross burn rate reduced.
How to reduce the cash burn rate
If the cash burn analysis shows that the monthly burn rate is very high, it is often worth looking at the costs in detail. Depending on what they consist of, various measures can then be taken to reduce the costs, for example:
- Savings in personnel costs
- Increase turnover through more sales
- Investing in product improvements, research & development, etc. to boost sales or reach new target groups.
- Sale of assets (e.g. capital investments or tangible assets)
- Taking out a loan for more freely available cash