How to Calculate Burn Rate
The current climate for startups is an uncertain one. In the first quarter of 2023, total venture capital raised by startups was down 80% compared to the same period in 2022, while venture deal count fell 45% over the same period. This has made fundraising increasingly difficult for many startups and small businesses.
Given this challenging landscape, it's more important than ever for startups to keep track of their burn rate. Burn rate helps companies and startups understand how money they lose each month and allows them to plan accordingly.
In this article, we'll explain what burn rate is, why it's important, and provide step-by-step instructions for how to calculate burn rate.
At G-Squared Partners, our team of experienced professionals has been helping startups and high-growth companies plan for financial success for over a decade. To get started on your journey to understanding burn rate and other important SaaS financial indicators, download our Ultimate Guide to SaaS Business Accounting.
What is Burn Rate?
Burn rate is an important measure to determine the amount of money that a company is losing each month.
A company’s gross burn rate is the amount of money it spends each month. Net burn rate, which is what most people refer to when discussing burn rate, is the amount of money a business spends, offset by any cash it collects.
A simple way to think about burn rate is the amount of money that your business loses every month, equivalent to negative cash flow or net losses. If a business had $100,000 in expenses each month, but only $25,000 in collections, it would be considered to have a burn rate of $75,000 per month. Burn rate should be calculated based on cash flow from operations, rather than the booked revenue for a period.
Understanding burn rate is crucial to both short-term planning and long-term forecasting. On a short-term basis, tracking burn rate helps startups track expenses and understand when funds might run out. On a longer-term basis, it can be used to assess the sustainability of a business model and determine whether additional investments or revenue sources are needed.
Step-by-Step Guide to Calculating Burn Rate
Understanding your business’s burn rate is essential when evaluating your business's financial health. This step-by-step guide will walk you through the process of how to calculate burn rate.
1. Identify the time period for calculation
The first step in most burn rate calculation methods is to identify the time period you will use for calculation. This could be weekly, monthly, or any other interval that works best for you and your startup. Burn rate is most often calculated on a monthly basis.
2. Determine total expenses for the chosen time period
To begin calculating startup burn rate, gather all your expenses for the given period. This includes rent and payroll costs, software subscriptions, hosting costs, and other recurring services needed for day-to-day operations. Pay attention to the cash that left your business’s bank account to pay for these expenses, rather than the expenses you recognized in your accounting system.
3. Exclude one-time or non-recurring expenses
To accurately calculate your monthly burn rate, it’s important to exclude one-time or non-recurring expenses such as one-off legal fees, taxes, or start-up costs that are not likely to be repeated in subsequent months.
4. Calculate average expenses
For your average expenses calculation, gather information about your fixed costs (e.g., rent, payroll, utilities) and your variable expenses (e.g., marketing, legal services). Once you have tallied these numbers, divide the total expenses by the number of months in the examined period to get your average monthly rate.
5. Calculate cash collections (if applicable) for the same time period
If your startup has paying customers, you also need to determine the total amount of cash it collected during the time period. This may involve looking at sales and other sources of income. Depending on the type of business, you may have to subtract refunds, chargebacks, and returns from total gross sales.
This calculation should reflect the cash your business actually collected from customers, rather than the revenue you booked. Many startups sell annual contracts where payment is collected in full up-front, but revenue is recognized over the duration of the contract. This can lead to inaccurate burn rate calculations, so it’s important to focus on cash flow over revenue.
6. Subtract cash collections from average monthly expenses
Once you have an exact figure for your total cash collections and average expenses, subtract the former from the latter to get your monthly burn rate. This will be a positive (profit) or negative (loss) number that reflects how much money was spent against incoming cash over one month.
7. Analyze and interpret the resulting burn rate figure
Analyzing and interpreting your business’s burn rate is critical in understanding how resources are allocated and managing cash flow. By reviewing past spending trends, understanding current expenditures, and comparing them with industry averages, you can use burn rate analysis to ensure that your burn rate aligns with your business objectives.
Tips to Manage Burn Rate
Founders should carefully track and manage monthly burn rate to take advantage of the available cash runway and ensure financial stability going forward. To do so, several burn rate optimization strategies can be implemented:
Long-term Financial Modeling and Budgeting: A core component of managing burn rate is having a long-term view of your organization's finances. By creating detailed financial models that look out over multiple years, you can identify areas where expenses could be reduced or delayed while maintaining an accurate picture of your budget projections. A clear understanding of your cash flow will help you identify opportunities for reducing costs or increasing income without disrupting operations.
Stress-testing Existing Forecasts: Once you have created a comprehensive financial model, it is vital to assess its accuracy. This can be achieved by stress-testing your existing projections and forecasting tools to explore a range of scenarios that may occur in the future. Doing so will ensure that you have a realistic outlook on the potential impacts of today's decisions on your financial situation.
Identifying Profit Drivers and Drainers: By understanding which areas of your organization are driving profits and which are draining them, you can better manage expenses and identify opportunities for improvement. Analyzing key performance indicators (KPIs) within each department will help you pinpoint where costs could be reduced while maintaining operational efficiency and quality.
Pivoting Strategy to Focus on Profitability Over Growth: While growth is a crucial component of any successful business, it is essential to ensure that growth efforts generate a positive return on investment. In the current fundraising environment, many startups are prioritizing profitability over growth. This approach doesn’t make sense for every business, but for some, focusing on driving incremental profits without significantly scaling operations or adding additional overhead costs can be a winning strategy.
Thoughtful Cost Cutting: Reducing costs does not necessarily mean sacrificing quality. Businesses can reduce their burn rate while still delivering by assessing each expense in their budget and identifying areas where savings can be made. This may include renegotiating existing contracts, switching vendors, or exploring remote-work solutions that could help organizations save on office space and other associated expenses. Question large investments in activities like product development to ensure they’re delivering a positive return.
Trim Non-Productive Sales & Marketing: Not every sale equates to profit – in fact, some customers actually drain your business’s resources. Identifying unprofitable sales and marketing activities, and then cutting these out, can help boost your business’s profitability.
Work with G-Squared Partners: Experienced Advisors to Startups
In the startup world, there are no quick fixes. Collaborating with seasoned advisors like G-Squared Partners greatly benefits businesses seeking to enhance financial performance and establish a strategy for long-term success.
At G-Squared Partners, our team of strategic advisors have years of experience in the startup industry and have the skills to provide guidance on topics including everything from cash management, fundraising, financial forecasting, and more. Our proven track record speaks volumes about our commitment to helping startups succeed by giving them the tools they need to reach new heights.
With G-Squared Partners on your side, you can rest assured that your business will be built on a firm financial footing. Reach out and get started today.