Understanding the Cash Burn Rate & How to Reduce It
One of the most critical reasons for failing a startup is running out of cash due to its mismanagement. Organizations can have a sustainable business by improving their cash burn rate and runway. Whether established or a startup, every stage requires funding to perform routine operations and expand the reach.
This article will explain the cash burn rate, how to calculate burn rate along with its burn rate formula, and how to reduce it to have a sustainable business.
So, let’s get started!
What is Cash Burn Rate?
Cash burn rate is when a company drains its capital in performing day-to-day operations and enhancing sales every month. It is a rate that gives you the amount of your monthly expenditure, which is used to measure the time left with the company before it goes out of cash.
Your burn rate is a measure that gives you an idea of how much cash you will regularly need to keep your business going. For example, if your cash burn rate is $414,000, it means you need $414,000 per month to fund your day-to-day operations.
What Does it Indicate?
A low burn rate is always preferable for the investors as it shows that the company is depleting its cash at a lower rate, indicating that funds will sustain until it starts giving positive cash flow.
Companies with high cash burn rates are likely to conceive a situation of financial distress.
Startups that burn cash are burning equity.” Kunal Shah – Founder of CRED
How to Calculate Cash Burn Rate?
Two concepts prevail in the investor’s community, to have a basic understanding of a company’s spending needs and liquidity position, cash burn rate, and cash runway.
The formula is relatively straightforward to calculate, especially when a company’s cash flow statement is available in hands. You can calculate cash burn rates using two methods – gross cash burn rate and net cash burn rate, so let’s look at each type to know how to calculate them.
Gross Cash Burn Rate
Gross cash burn is the total operating expenses of an ent, and it is calculated by summing up all the expenditure that attempts to make sales. In other words, it will give you an idea of how much your company needs to perform the main activity of your business.
The operating expenses will typically include factory rent, direct wages, and other related costs to carry out the business’s main activity.
Suppose a business needs $125,000 to perform operating activities (except for office and other expenses), then the gross cash burn rate would be $125,000.
Net Cash Burn Rate
The net cash burn rate considers sales income, and it determines the net burn rate by subtracting all expenses from the sales income of that month.
Let’s say you sold products worth $50,000 in a month, and the total expenses of that month were $370,000, then your net cash burn rate would be $320,000 ($50,000 – $370,000).
Similarly, if you want to know how much time you have until you go out of cash in your business, you should use the cash runway formula. It helps you determine focus on increasing positive cash flows and how much time we have to make the business profitable.
For example, you have $500,000 in banks or hands. And, your gross cash burn is $100,000 per month, then your cash runway will be five months ($500,000 / $100,000). It means you have five months until you will go out of money.
Importance of a Cash Burn Rate
- The investors decide whether to invest in a startup business based on the company’s cash burn rate.
- It tells you whether the expenses made are generating any positive cash flow or not.
- The rate gives you an idea of how much time you will have until you run out of money to carry out your business.
- Businesses can compare their spending efficiency that derives cost per output by using cash burn methods.
- For any start-up or sick business unit which is not generating any cash inflow, calculating the burn rate would be a valuable tool to set objectives and attempts to achieve them.
Now let’s look at the steps to reduce or maintain a desirable cash burn rate to run your business effectively.
8 Key Tips to Keep Your Cash Burn Rate Low
Cut Down Redundant Expenditures
Eliminating non-essential costs & expenses can help to cut down redundant expenditures. Also, observing & eliminating the lack of sincerity in work done by the employee by evaluating efficient payroll will help reduce the cash outflow.
Putting a pause at voluntary over time can help keep staff budget intact. Outsourcing partial and task-based jobs could be a better strategy to limit your cash outflow.
Aim to Increase Profit-margin
Price raising can help get more cash inflow without bearing extra cost or outflow. Retaining existing consumers & getting repetitive sales may help increase profit margin while reducing the cost of acquiring a customer.
Increase Cash Sales
With the ease of getting EMI approvals and online shopping at your fingertips, the world is heading towards credit purchase. Credit purchases are strategically best to acquire new consumers; this is a heavy cash burden.
Promoting cash sales might not sound good but is undoubtedly beneficial for cash inflow. Offline presence is a fantastic way to drive more cash sales. Also, early booking & advance payment offers could positively affect the cash inflow with sales.
Get Extended Credit Periods to Make Repayments
Suppliers significantly influence cash flow; paying early or high credit rates can heavily affect. Calculating the cost of money will help decide payment schedules for suppliers, and paying bills later and with slow frequency might help keep cash flow stable. Asking for more credit periods from suppliers is beneficial for reducing cash outflow.
Get Additional Funding
More funds facilitate businesses to be playful with cash flow. Getting additional funding for a business increases cash inflow while keeping the cash outflow & essential expenses parallelly the same. However, the cost of acquiring new financing should be carefully observed.
Manage Debt Efficiently
Debt is the business burden that asks for repayment in a specified period. The business faces serious cash out at the time of repayments, as they do not have any confirmed source cash inflow.
Refinancing debt means applying for a new debt instrument or loan with better terms than previous debt. It also allows repaying previous debts and sets off the liabilities. This method of repaying debt is also known as debt consolidation.
Try Just-in-time Inventory
A just-in-time inventory system is a management strategy that allows a company to keep a minimum amount of inventory on hand to meet the demand. Application of just-in-time inventory system, business doesn’t need storage & management for the stocks, which helps save cost & outflow of extra cash. It reduces the cost of damaged inventory.
Short-term Credits for Major Purchases
Short-term financing means the financing for the smaller period of less than one year, and it helps the businesses generate cash for work in progress and operating expenses. Short-term credits could be for 15 days, two months, or 7 to eight months.
The Bottom Line
The cash burn rate is crucial for start-up companies because they may not generate profits initially, and hence, the cash flow will also not be positive.
So, it will help you understand whether you are on track to generating positive cash flows and how much time you have until you use all the money you have.