Calculating Burn Rate
You might have recently seen me covering burn rate on our 60-second crash course video series over on Twitter. If not, it’s below.
But there’s only so much that can be covered in 60 seconds, so let’s dive a little deeper.
“Burn Rate” is commonly defined as the amount of cash that a company loses in an average month. This term is usually associated with high-growth startups, many are unprofitable from the get-go and rely on outside funding to keep them alive. Typically, they will raise enough money from investors to fund 12-18 months of operations. On the quest for growth, the company will “burn” through this cash by spending on employees, rent, travel, etc. Ideally, this burn rate will continue to decrease until the startup eventually reaches profitability or needs to raise additional funding.
Burn rate can be calculated many ways. Most founders believe that net income and burn rate are one in the same, but this is far from true. Depending on a company’s business model, net income and burn rate can be nearly identical or wildly different. Let’s investigate why this is:
Delayed Receipts/ Payment
Just because revenue is booked within a certain month doesn’t mean that the cash associated with that revenue is collected within the same month. In fact, this is almost never the case. Most companies negotiate payment terms with their customers. Customers may have 30 or 60 days to pay an invoice, and a lot of customers will wait until the very end of that term to pay. Some companies may choose to pay late, or perhaps not at all. This can differ from company to company. For example, Self-Serve SaaS companies like Netflix don’t have to worry about long payment terms because they auto-withdraw a user’s credit card.
Similarly, in the same way that clients might slow pay their invoices, you too can slow pay some of your bills. Think about bills that you have received where the payment isn’t due for 60 days. Even though you record the cost when it is incurred (GAAP) you may not actually pay the invoice until a few months later. Therefore, it is crucial to consider factoring in accounts payable and accounts receivable when forecasting cash balances.
One of the largest, most predictable, costs hidden from the income statement are principal payments on outstanding and future debt. During the life of a typical loan, principal payments become larger as the loan gets closer and closer to maturity, though the total payment usually remain consistent throughout. While interest is accounted for on the income statement (it is tax deductible) principal payments are not. Depending on the capital stack of the company, these payments can be massive. It is not uncommon for startups to opt for debt over equity to minimize dilution. While this can be a good option, it is important to account for paying down principal when predicting cash flow.
Capital expenditures are the expenses that you wouldn’t record on the income statement. Think about large, non-reoccurring purchases like equipment or Land. Instead of including these expenses on the income statement, which would demolish the net income in the month that they were recorded, these expenses are spread over a long period of time via depreciation. This practice overstates your income statement burn rate in subsequent months because depreciation is non-cash charge. Because of this, it is important to ignore depreciation when analyzing cash burn rate. It is still, however, important to budget for large capital expenses in the future.
There are a variety of factors influencing the burn rate that are not reflected in the income statement. A good rule of thumb for analyzing burn rate is not to look at the monthly incomes statement, but instead to the statement of cash flows. Look at the trend for of the monthly changes in cash and exclude any large swings in debt or equity. Doing this will give you the best estimation of your true burn rate because it reflects that is happening in your bank account on a given month.
When forecasting cash going forward, it’s important to forecast not only the income statement, but the balance sheet as well. This will ensure that accounts payable / receivable will be included, as well as amortization of debt and capital expenditures. This step is often neglected, but crucial when creating a solid forecast for burn rate, therefore cash.