Cash is the fuel that keeps your business going. Whether it’s through cost of goods sold, payroll, or advertising, every company spends money to operate and grow.
But what if you spend too much? You could find yourself in a cash burn situation.
Cash burn isn’t always a bad thing. Especially from my experience in the startup world – formerly as a finance exec for two Seattle-based unicorns and now as the CFO of Trovata – it’s often an expected part of launching a new business. Even so, it’s vital to understand how much runway you have to allow for proper planning for the future.
What is Cash Burn?
If you’re experiencing cash burn, it means your business is spending money faster than it’s earning it. Cash burn is a key KPI closely related to another important metric, cash flow. Specifically, cash burn is a measurement of negative cash flow (net decrease in cash over time).
Especially for startups, cash burn is like walking a tightrope – you want to spend enough money to keep your business growing or hit that next milestone, but not so much money that expenditures consistently outweigh revenue.
If it does, you’ll have a cash out date – a day on which the company completely runs out of cash.
Of course, you’ll only run out of money if you don’t make the necessary adjustments. These could involve cutting costs, increasing income, or raising additional capital. Cash burn rate is the speed at which your cash reserves are dwindling. This is usually calculated per month.
Your cash runway is the amount of time you have before you run out of money. Obviously, the longer, the better, as you’ll have more time to focus on executing business initiatives and more options to tweak your company’s cash situation along the way. There are two different types of burn rate: gross burn rate and net burn rate.
Gross Burn Rate vs. Net Burn Rate
Gross burn rate shows how much money your company is spending, without considering how much it’s earning.
The gross burn rate can be useful in showing the company’s overall cash position. It helps give a clear picture by eliminating bias caused by particularly profitable periods. For example, if your business is seasonal, gross burn rate is going to be more useful for you than it would be for companies making similar profits year-round.
In contrast to gross burn rate, net burn rate does take your company’s earnings into account. It shows if you’re losing money even when your monthly inflows from revenue-generating activities is added.
Most of the time, when people talk about burn rate, they mean net burn rate.
You’ll always have a gross burn rate – every business spends money – but only have a net burn rate when you have a negative cash flow. So, when we’re looking at how long a cash runway is, it’s the net burn rate we’re interested in.
How to Calculate Net Cash Burn Rate
Net cash burn rate = Beginning cash balance – Ending cash balance / Number of months
First, decide how long a period you want to evaluate.
Though cash burn shows the amount lost per month, you’ll want to choose a period longer than one month – one very good month or one very bad month could be misleading. Let’s say you choose a 4-month period. Using your cash flow statement, find your balance at the beginning of those 4 months and your balance at the end of those 4 months.
Maybe it’s $200,000 in January, and $130,000 in April.
We subtract the ending amount from the starting amount: $200,000 – $130,000 = $70,000
To figure out how much you’re losing per month, simply divide $70,000 by the number of months in the period.
$70,000/4 = $17,500
So, your net burn rate is $17,500 per month.
Using this number, we can figure out the length of your cash runway. Divide the funds you have right now – in this example, $130,000 at the beginning of April – by your net burn rate:
$130,000/$17,500 = 7.42
This tells us that – if revenue and expenses remain the same – your company will run out of money in about seven and a half months.
What’s a Good Cash Burn Rate?
Ideally, you’d have no net burn rate and a positive cash flow. However, sometimes it’s necessary to dip a bit into the red to grow your business. Six months to a year is a good range to aim for, leaning towards a year.
Remember that, similar to cash flow, cash burn is a running, point-in-time metric.
If you perform a cash burn calculation and see that your reserves will run out in 7 and a half months, keep in mind this figure is based on current spending and income levels. If you have reasonable expectations that revenue will be higher in 2 months, for instance, you don’t have to take the cash burn rate at face value.
But if revenue levels are expected to stay the same, or even dip, then you may want to start cutting costs. So, let’s say your burn rate is much higher than you’re comfortable with. Perhaps you’re projected to run out of funds in 5 months.
What steps can you take to get it under control?
How to Reduce Cash Burn Rate
Take a hard look at your budget – you’ll probably find at least a few unnecessary or redundant expenses among your recent credit card statements. For example, maybe you’re paying for SaaS tools you don’t really use or can consolidate. For those you do use, you could be paying for extra features that aren’t really relevant to your business – consider switching to a cheaper or even free plan. You may pay paying for extra users who don’t really need access to certain systems or tools.
Next, maybe you don’t need that big office space right now? Working remotely could be as just as effective. Likewise, although it would be ideal to fly to meet your new client in person, you could always opt for a free video call that could facilitate the same deal.
Lastly, consider if you need that additional full-time employee. Maybe you can leverage technology to scale processes or outsource work for specialized tasks. Using digital tools, you can drive automation giving people time back or eliminating manual tasks that would require hiring additional headcount to perform. Hiring a contractor can provide more flexibility in controlling costs and obtaining subject matter expertise to accomplish various projects.
Reassess Your Strategy
Do you have a variety of products for sale? This is one method used to boost growth but, right now, you might have some that don’t sell. Assess each type of product and, if one has lower profit margins, carries a significant customer acquisition cost or is simply costing you more than it’s bringing in, cut it.
Even if you’re breaking even, you could cut it and double down into revenue streams you know are more profitable and more efficient to sell. Don’t worry – you can always bring those products back later.
Maybe you’ve been advertising on a specific social network, but haven’t seen great returns. While some more work and research could help in the future, right now it’s not worth the cost – get rid of it!
Rethink Your Loans
When it comes to loans, there are three things you can do:
- Make the switch to interest-only loans.
- See if you can refinance your loans with more favorable conditions.
- Delay payment as long as you can without incurring fees.
What about accessing new capital from a loan? Won’t that help lengthen your runway?
Possibly, but you should really only take out new loans as a last resort. If you find you have no choice, run another cash burn calculation with the new starting amount (add the loan to what you have now) and costs to get an idea if a specific loan is sustainable before you take it out.
Depending on your business, raising capital via equity could be an option. This could include going back to original investors if you’ve raised money previously, opening a funding round for new investors, or a combination of both.
In addition to negotiating with creditors, try negotiating with suppliers. If you explain the situation to them you may be able to restructure payment terms, payment schedules, or at least delay payment on what you owe. Be careful not to burn any bridges though, or this could come back to bite you in the future.
Revisit your pricing. Try making small price increases to your products – every bit helps. Review your products and service obligations and ensure pricing is aligned with the value customers are willing to pay for. Consider making only small increases you reduce the chances of losing customers.
You may be tempted to spend some money to try and boost revenue. Maybe you’ve found the perfect social network for your product and want to launch a new marketing campaign. My advice? Be very careful if cash is already tight. You can never be 100% sure of these things and, while it could work, it could also end up shortening your cash runway. Right now you want more wiggle room, not less.
Accounts receivable are great and all, but if payments take too long they’re not going to help your cash situation now.
To increase the rate at which you get paid, be sure to send invoices right away. Consider providing incentives for those who pay early, perhaps a discount or an additional product you’ve had trouble selling.
Bill, then collect, collect, collect and boost that working capital!
How Trovata Can Help
Cash flow and cash burn rate are two sometimes overlooked treasury metrics that are nevertheless critical to the future of your business. No operation can survive without cash, and running the numbers helps you plan ahead and avoid a crisis.
Trovata can help you get a crystal clear picture of your cash situation, allowing you to more accurately calculate your burn rate and runway. Through the use of open banking and machine learning algorithms, you can see your data across accounts, and avoid problematic cash burn with reliable forecasts.