What is Cash Burn and Why Is It Important?

As a business owner you are aware that operating your business requires cash. Stocking inventory, financing payroll, and purchasing new equipment, among other things, require a healthy reserve of cash. In fact, almost a third of all new companies that fail do so because they run out of operating cash. Most of these companies failed to understand what their cash burn was.

You might not be aware of the concept of cash burn and how this metric is a powerful planning tool for small businesses. Paying attention to the rate that your business burns cash can make a huge difference. In many situations, it is the difference between operating smoothly and shuttering because of an inability to pay costs. 

This article will define cash burn and how it is calculated. We’ll go into more detail about why it is an important metric — and how accounting services professoinals can help you put it to the best use.  

What is cash burn rate?

Put simply, cash burn rate — or just “cash burn” — is the rate at which a company spends it’s available cash. Cash burn is most often calculated on a monthly basis. In some situations it can be expressed as a weekly or daily rate. It is important that business owner’s pay attention to their company’s burn rate. Having too high or too low of a rate can indicate problems with a company’s financial health. 

In contrast to similar metrics, cash burn rate takes into account a company’s revenue and cash flow. It is a measure of how long a company has before it must begin generating positive cash flow or risk going out of business.

The Cash Burn Calculation

In order to calculate cash burn rate, business owners need to be familiar with their cash flow statement. The cash flow statements is a report showing how much cash a company has on hand, and how cash has flowed in and out of the company. Cash burn rate is the total change in cash on hand over a period of time:

Cash Burn Rate = Change in Cash On Hand/Period of Time

A company’s cash burn rate can be used to calculate even more important metrics in turn. The amount of time a company can operate is calculated by dividing on-hand cash by the cash burn rate:

Operating Time Remaining = Cash On Hand/Cash Burn Rate

If these formulas seem unapproachable to you, then you aren’t alone. Most small to medium-sized business owner’s aren’t financial professionals, and concepts like cash burn and cash flow can be complex. If you find yourself having trouble calculating your cash burn rate, consider consulting with a professional accountant, like a virtual CFO or controller.  

What factors impact a company’s cash burn rate?

As a small business owner, you are probably aware that many factors affect your company’s finances, and that determining an exact cause for a certain financial metric can be tricky. So, although the following list isn’t exhaustive, it does describe a few factors that impact cash burn rate: 

Changing Total Expenses

Expenses, as a whole, might be the easiest concept to imagine impacting cash burn. They represent the ways that your company spends money, or reduces it’s on-hand cash. Expenses can change quickly, though, especially in startup companies. You may have heard the financial term “variable costs,” which defines the kinds of costs that change over time. The amount of inventory a company needs to order, for example, or the cost of payroll in a company that is rapidly hiring more employees. 

It is a good idea to review cash flow statements regularly. But keeping track of changing expenses is particularly helpful in understanding your company’s cash burn. You’ll want to know if the costs of stocking a new product will make your cash burn unacceptably high. Or how changing marketing costs will impact the amount of time you have before all of your on-hand cash is spent.

Changing On-hand Cash Reserves

The other side of the cash burn rate equation, apart from expenses, is how much on-hand cash a company has. Like expenses, this amount can change rapidly. Knowing the amount of on-hand cash your company has is the best way to determine the “runway” it has. Runway is the amount of time it can operate before going out of business for lack of cash. 

One mainstay way that on-hand cash changes for a small to medium-sized business is through outside investment. Your company going through a round of investor funding will definitely mean a significant change in the amount of on-hand cash you have, for instance. You’ll want to be keenly aware of the terms of any investment partnership that your business enters into. This includes the stake that investors are owed and how resulting stock option payouts or new payroll costs will affect revenue, among other things.

The Cash Gap

A business’ cash gap is the time between its cash outflows and cash inflows. A food manufacturer might pay to stock its inventory, and then need to wait for a period before the sales of that inventory produce cash. 

The longer your business’ cash gap, the more on-hand cash you will need to cover operating expenses. Burning cash too quickly and having too large a cash gap could result in your business is waiting for payments but can’t pay operating costs during the gap.

The importance of knowing your cash burn rate

By now, you’re probably aware that cash burn rate is important. Why, specifically, do business owners need to be concerned with it, though? 

First and foremost, the rate your business is burning cash determines how long it will be able to operate before going out of business. Most successful small businesses plan to keep on-hand operating cash that will allow them to stay up and running for 12 to 24 months. This way an unforeseen cost or financial shakeup doesn’t take them by surprise. The only way to know your business’ runway or the amount of time it can operate without running out of cash, is by understanding its cash burn rate.

Second, if you are planning on undergoing a funding round or courting outside investment, knowing your cash burn rate is a crucial step. Investors want to know that the business they are giving capital too has thought carefully about how it will use that capital.

Imagine going into a meeting with a potential investment partner. Not being able to answer how long your business would be able to operate without positive cash flow would sink a potential deal. Not understanding a financial metric as important as cash burn is a surefire way to dissuade investors.

Finally, burning cash too quickly or slowly is a serious problem. In order to diagnose the cause, you need to be aware that the issue exists. Understanding that your business will only be able to operate for 6 more months at its current cash burn rate is better than turning a blind eye to the issue. You can make necessary changes before the worst happens. Businesses that are burning cash too quickly might choose to seek new revenue streams, renegotiate loan terms, or reconsider the cash they are putting towards rent.

Other Articles To Read

Decoding Accounting – The Cash Gap

The Cash Flow Statement Primer

The Essential KPIs Your Small Business Should Be Tracking in 2021

How Krieger Analytics Can Help

Krieger Analytics specializes in outsourcing accounting services for small businesses, from bookkeeping to virtual CFO consultations. Our background in entrapuernship and finance means we know what running a business entails. We want to meet your accounting needs without burdening you with the costs of a full-time accounting staff. We understand your position as a small business owner, because we have experience running businesses ourselves. 

Have questions about anything discussed in this article, or interested in what valuable insights a CFO have for your business? Conversations are free, so don’t hesitate to reach out at [email protected]. Let us explain how our accounting services could be the right fit for you.