Burn Rate
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Burn rate is how quickly a company uses up its capital to finance operations before generating positive cash flow from operations. This rate is a critical key to survival in the case of small, fast growing companies that need constant access to capital. Many technology and Internet companies are examples. It is not uncommon for enterprises to lose money in their early goings, but it is important for financial analysts and investors to assess how much those firms are taking in and using up.
The number to examine is free cash flow, which is the company's operating cash flows minus cash outlays for capital spending. It is the amount available to finance planned expansion of operating capacity.
Burn rate is generally used in terms of cash spent per month. A burn rate of 1 million would mean the company is spending 1 million per month. When the burn rate begins to exceed plan or revenue fails to meet expectations, the usual recourse is to reduce the burn rate. In order to stay afloat, the business will have to reduce the staff, cut spending, or raise new capital, probably by taking on debt or by selling additional equity stock[1].
Burn Rate Vs Return Rate
Burn rate tells the per month payment of cash for various expenses when we start a new business. For example, a person makes partnership firm for selling the small family products. For this, he has to invest money in the form of raw materials, shops, vehicles and other expenses in new partnership. If we calculate it and find per month cash expenses, it will our burn rate.
Return rate is the rate of return on total investment. If you get money from other, you will tell the return rate not burn rate. But it is the duty of investor to estimate the burn rate before investing the money. Past cash flow statements may help to find burn rate in which you are investing your money. If you see that company is burning your cash with high burning rate, you should start using smaller bills[2].
Reasons why burn rate is important
The burn rate is determined by looking at the cash flow statement. The cash flow statement reports the change in the firm's cash position from one period to the next by accounting for the cash flows from operations, investment activities, and financing activities. Compared to the amount of cash a company has on hand, the burn rate gives investors a sense of how much time is left before the company runs out of cash-assuming no change in the burn rate. This time period is called the "runway".
Time left before cash runs out= Burn rate
If you want to know if a company is really in trouble, compare its burn rate with the working capital measured over the same time period. The burn rate is important for two reasons[3]:
- It provides the business manager with a financial picture of where the company is going and what needs to be done before cash becomes a problem.
- It allows management to dynamically analyze the financial position of the business and determine how long the business can operate if changes are not made to its operations.
Footnotes
References
- Kaplan J.M., Warren A.C., (2010), Patterns of Entrepreneurship Management, John Wiley & Sons, New Jersey.
- Kumar V., (2019), Accounting Dictionary, CRC Press, London.
- Shim J.K., Constas M., (2016), International Finance and Banking, CRC Press, Washington.
Author: Brygida Mordarska
