Burn Rate
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.
Examples of Burn Rate
- Cash Burn Rate: This is the rate at which a company is losing cash. It is calculated by subtracting cash outflows from cash inflows. Cash burn rate is an important metric to measure a company's financial health, as it shows how quickly a company is using up its cash reserves.
- Sales Burn Rate: This is the rate at which a company is selling its products or services. It is calculated by subtracting sales outflows from sales inflows. It is important to monitor this metric to ensure that the company is generating enough revenue to cover its costs and remain profitable.
- Operating Burn Rate: This is the rate at which a company is spending money to run its operations. It is calculated by subtracting operating expenses from operating income. This metric is important to measure a company's efficiency and its ability to generate profits from its operations.
- Equity Burn Rate: This is the rate at which a company is using up its equity capital to finance operations. It is calculated by subtracting equity outflows from equity inflows. This is an important metric to measure a company's liquidity and its ability to remain solvent.
Advantages of Burn Rate
A burn rate can be a useful tool for understanding a company's financial health. It can provide insight into how quickly a company is using up its resources and help to identify potential issues before they become a major problem. The advantages of monitoring a company's burn rate include:
- Improved Cash Flow: By tracking a company's burn rate, it is possible to identify potential problems with cash flow before they become a major issue. This can help to ensure that the company has the resources available to finance operations and pay bills on time.
- Improved Cost Management: By tracking a company's burn rate, it is possible to identify areas where costs can be reduced or eliminated. This can help to ensure that the company is operating as efficiently as possible.
- Increased Investment Transparency: By monitoring a company's burn rate, investors can gain insight into how the company is using its resources and if it is able to generate positive cash flow from operations. This can help to increase transparency and provide investors with the confidence they need to invest.
Limitations of Burn Rate
Burn rate can be a useful metric to evaluate a company's financial health, but it also has its limitations. The following are some of the main drawbacks of using burn rate to assess a company’s financial performance:
- Burn rate does not take into account the amount of revenue generated from operations each month. This means that a company could be burning through its capital quickly but still generating a profit from its sales.
- Burn rate does not consider the company's long-term strategy, which may involve investing in new products or services that may not pay off until the future.
- Burn rate does not tell us how much of the company's expenses are fixed and which are variable. If a company increases its expenses on a regular basis, the burn rate may not reflect this.
- Burn rate also does not necessarily reflect the company's ability to raise additional capital. It can be difficult to gauge whether a company has access to more capital if it is burning through its existing capital quickly.
Burn rate is not only a measure of how quickly a company uses up its capital, but also a measure of how well it is managing its finances. Other approaches used to measure financial health and performance include:
- Cash Flow Analysis: This approach looks at the actual cash flow of a company, rather than its income, which can be affected by accounting decisions. It also looks at how quickly a company is taking in cash, and how quickly it is paying out cash, which can be a better measure of financial health than income alone.
- Break-Even Analysis: This looks at the point at which a company's income equals its expenses, including overhead costs. It helps to determine how much of a product or service needs to be sold in order to become profitable.
- Ratio Analysis: This approach looks at ratios such as the debt to equity ratio, which measures the amount of debt a company is carrying relative to its equity, or the current ratio, which measures the ability of a company to pay short-term debts.
In summary, burn rate is a critical measure of financial health, but other approaches such as cash flow analysis, break-even analysis, and ratio analysis can also give a better picture of a company's performance.
Footnotes
| Burn Rate — recommended articles |
| Solvency ratios — Defensive interval ratio — Cash Flow-to-Debt Ratio — Activity ratios — Capital gearing — Average collection period — Accounting ratios — Du Pont analysis — Return on net assets |
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
