As a startup founder, you may have been asked for your startup’s burn rate. Simply put, a startup’s burn rate is the rate at which a startup is spending (or ‘burning’) cash. It is a metric most often used in early-stage companies that are not yet profitable to measure how quickly they are running out of cash on a monthly basis. In other words, burn rate is a term that means ‘negative cash flow’. So, if a startup CEO claims their startup has a burn rate of $2 million, that means their startup is losing money at a rate of $500,000 per month.
Net Burn Rate vs. Gross Burn Rate
There are two kinds of burn rate: Gross Burn Rate and Net Burn Rate. Gross Burn Rate is the rate at which you are spending cash without taking into account how much revenue you earn. Net Burn Rate is the rate at which you are spending cash, offset by how much revenue you earn. Gross Burn Rate and Net Burn Rate are calculated as follows:
Net Burn Rate = Revenue – Cost of Goods Sold – Operating Expenses
Gross Burn Rate = – Operating Expenses
For example, if your company earns $100 in Revenue in a given month, spent $80 on Cost of Goods Sold, and spent $40 on Operational Expenses, your Net Burn Rate is –$20, while your Gross Burn Rate is –$120.
Net Burn Rate = $100 – $80 – $40 = –$20
Gross Burn Rate = – $80 – $40 = –$120
What is my startup’s runway, and how is it related to my startup burn rate?
Note that your startup’s runway will look different depending on whether you use gross burn rate or net burn rate.
Because a startup’s burn rate is a measure of negative cash flow, a startup can use its burn rate to determine how much time it has before it will run out of cash – its Runway – which is usually measured in months. To do this, a startup can take their cash balance at any given time and divide it by its runway.
Note that your startup’s runway will be different depending on whether you use gross burn rate or net burn rate:
Gross Runway = Cash Balance / Gross Burn Rate
Net Runway = Cash Balance / Net Burn Rate
If your company has $1,000 in the bank, earned $100 in revenue in a given month, and in that same month spent $80 on COGS, and $40 on Operational Expenses, your Net Burn Rate is –$20, and your Gross Burn Rate is –$120. Your runway is…
Gross Runway = $1,000 / $120 = 8 months
Net Runway = $1,000 / $20 = 50 months
Your net runway tells you that, assuming your revenue and cost structure remains consistent, you have 50 months before your startup runs out of money. Your gross runway tells you that if your business performance changes (in other words, if sales decrease or costs increase) you have roughly 8 months to figure out a plan before you run out of money.
How do I calculate startup burn rate if using accrual basis accounting?
Calculating your burn rate is different depending on whether you’re using cash basis accounting or accrual basis accounting. If you’re using cash basis accounting, you can focus on your income statement to calculate your burn rate, as with the example above. However, if you’re using accrual basis accounting, you must also consider certain balance sheet items that impact your cash balance on a monthly basis.
One example of accrual basis accounting impacting a startup’s burn rate calculation is dealing with the purchase of inventory. Using accrual basis accounting, a $1,200 inventory purchase decreases your Cash balance sheet account by $1,200 and increases your Inventory balance sheet account by $1,200. In subsequent months, as that inventory is sold, a Cost of Goods Sold (or “COGS”) expense will hit the income statement for the cost of the inventory that is sold in that month. In our example, if we assume that $100 worth of inventory is sold each month, a COGS expense of $100 will appear on the income statement each month.
To recap our example, $1,200 worth of inventory was purchased with cash in Month 1, and $100 worth of COGS expense will hit the income statement each subsequent month until that inventory is gone. How do we deal with the impact of this inventory purchase on a startup’s burn rate under accrual accounting?
Accrual accounting burn rate example:
To calculate the impact of this inventory purchase on your startup’s burn rate under accrual accounting, you must do two things.
First, you must calculate the change in inventory between the current month and the previous month:
Change in Inventory = Current Month Inventory – Previous Month Inventory
Then, you must add the Change in Inventory to your burn rate.
In Month 1, when you purchased the inventory, the overall effect to your startup’s burn rate is as follows:
Starting inventory balance: $0
Ending Inventory balance: $1,200
Change in Inventory: $1,200
COGS Expense: $0 (because no inventory was sold this month)
Burn Rate: –$1,200
In the second month, when you did not purchase anything, and you sold $100 worth of inventory, this is how your startup’s burn rate is impacted:
Starting inventory balance: $1,200
Ending Inventory balance: $1,100
Change in Inventory: –$100
COGS Expense: $100
Burn Rate: $0
As you can see, the Change in Inventory effectively ‘cancels out’ the impact of the accrued COGS expense, as it is a non-cash expense in that period.
Note that inventory isn’t the only balance sheet account that impacts burn rate. Other common balance sheet accounts that impact burn rate include Accounts Payable, Accounts Receivable, Prepaid Revenue, and Accrued Expenses.
What does it mean to cut my startup burn rate?
Some startups may experience a higher burn rate than they are anticipating, or lower revenue than they predict. In these cases, the plan of action should be to reduce (or ‘cut’) burn rate. This process involves taking a hard look at your startup’s cost structure and making hard decisions to eliminate some expenses in order to reduce your burn rate and increase the amount of time your company has before it runs out of money.
What should my startup’s burn rate be?
Startups will generally want enough cash in the bank to fund between 12 and 18 months of expenses. So, if a company has $500,000 in the bank, a good burn rate would be somewhere between $27,777 per month (18 months) and $41,666 (12 months).
How can I calculate my startup’s burn rate?
We’ve got some free resources available to get you started. Founder’s CPA has a team of experts that can help you plan for the future by calculating your startup’s burn rate.
Contact the startup finance experts at Founder’s CPA today to learn how you can get more from your financial statements.
