Why do you need Cash Burn Rate?
What is Cash Burn Rate?
The cash burn rate is when any new company is spending its cash and reserves to finance its overheads. It is generally considered a negative cash flow. The capital spent during the initial phase of the startup is known as the cash burn rate. The first goal of every new company is to improve the customer base, and they are not able to generate positive cash flow. If a company is spending $1 million per month, the cash burn rate will be $1 million.
Understanding the Cash Burn Rate
This rate is usually used by startup companies to check the amount of cash spent before generating their income. It is also used to calculate the amount of time a company has before it runs out of money. This is known as the company’s runaway time. If a company has $100,000 and spends $10,000 per month, the burn rate would be $10,000. Similarly, the runaway duration would be ten months.
$100,000 / $10,000 = 10 months. When the company burns the cash faster, they might run out of money and lose the business. On the other hand, when the burn rate is too low, it affects the company’s future planning and investments. All the information related to the cash burn is present in the cash flow statement. An investor always looks for the company’s excess cash, capital expenditure, and cash burn rate before investing.
Why do you need the rate?
Cash comes under the primary resources of starting a business. The more you spend, the higher your cash burn is. But the critical question is, do you also make something out of it? Most startups grow on funding, and for that, they require investments. For the initial investments, investors look at your financial position and how well you manage your expenses. If the company spends too much cash, then the investor might be reluctant to invest in money. They do consider the importance and uses of money before providing funds. A cash burn helps the company to measure its sustainability and know about future financing.
The rate is also used by mature companies when they are struggling with excessive debt. Airline companies went through a massive crisis after 9/11. For example, United Airlines faced a daily cash burn of $7 million before they requested bankruptcy protection. Moreover, when a company is working on its financial model, it is essential to know the burn rate. Startups mostly require funding through phases, so it is necessary to know how long the company can last on immediate cash.
How to calculate the cash burn rate?
The Cash Flow Statement of any company is made by calculating cash flows from operating, investing, and financing activities. The burn rate can be seen from the position of the cash flow statement. The formula for the rate is:
Burn Rate = Change in Cash Position / Specified Time Period
The investors can check how much time is left before the company runs out of cash by:
Time Before the company runs out of cash = Cash Reserves / Cash Burn Rate.
The burn rate can also be compared with the working capital to know if the company is in some trouble.
When an investor is willing to do the funding, the companies can recover the cash burns by issuing new shares. Later, the company needs to show the profitability and income generated over time. A person would not invest in a business where the rate is high. As a result, a company can get itself trapped by accepting unfavorable financing terms. Creditors will take advantage of their position and offer them to merge. The business might even go bankrupt. Cash Burn Rate plays a crucial role in determining the initial funding phase. It is one of the factors which helps you maintain a stable position in front of your investor.
We, at Oak Business Consultant, are specialized in providing consultation on these matters. We have helped several companies in building a robust financial model and business plan along with Pitch Deck. Therefore, you can visit our website Oak Business Consultant to consult with us for free.