How to Calculate Burn Rate During a Downturn
Written by Amanda Bower | Published: November 1, 2022
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As a new business, you may have heard about the term “burn rate.” However, do you truly know what it means? Unfortunately, many new companies either do not understand the significance behind this critical term or have no idea how to calculate it or what to do with this figure.
Yet, by failing to invest the time to learn everything you can about this rate, you risk not being able to plan for economic downturns, create solid plans to help your business grow, or recognize how your company operates.
As a result, not having this intel can mean bad news for startups and small businesses, as studies show that approximately 82% of small businesses fail because of cash flow issues. That is why in the below guide, we will go over everything you need to know about the burn rate, including how to compute it and how this calculation can help you during an economic downturn.
Why Does the Burn Rate Matter?
The burn rate is the rate at which a company spends its capital to finance costs and other overhead expenses before generating cash flow from its operations. Simply put, the burn rate measures negative cash flow or how fast a business goes through its capital.
Yet, while it is usually new businesses that use the burn rate, all companies can benefit from knowing it. For instance, when a new business venture is looking to obtain capital for its startup, an investor will typically look at whether the business has a low burn rate. This can indicate that their money will go farther in the business, and it is more plausible that the company will become profitable, helping the investor make a return on their investment.
On the other hand, an older, well-established business can use the burn rate to help them determine its position during times of a downturn. For instance, the company can use this rate to gauge its cash position, allowing them to figure out the business’s overall health.
Why Is It Important to Adjust During an Economic Downturn?
During an economic downturn, companies need to adjust so that they are better prepared to endure a period of negative cash flow. During this time, the company needs to develop new strategies that can help market its business effectively, expand its clientele, and improve overall business practices without increasing costs.
That is why calculating the burn rate during an economic downturn is so effective, as it can help you figure out what elements you will need to adjust during this downturn and how to manage your financial position best.
How Do You Calculate the Burn Rate?
While there are numerous ways to compute the burn rate, the bottom line is that all these equations will report how fast the business is eating up its cash reserves.
Below, we will go over one of the more common burn rate calculations.
The Burn Rate = (The Starting Cash Balance – the Ending Cash Balance) / Number of Months
To complete this equation, you will first need to have an updated balance sheet to be able to find the appropriate figures. From there, you will have to complete the following steps:
- Figure out the period you need to evaluate. For instance, if you are looking at the first quarter, you will have to examine the three-month period from January to March. Yet, it is essential to note that because the burn rate is considered a current metric, you should look at a more recent period of time.
- Next, review your balance sheet and find the cash balance for the start and end of the period in question.
- You will then subtract the ending cash balance from the beginning cash balance.
- Finally, divide the difference by the number of months you are reviewing. The final number will be the cash burn per month.
In addition, as you are calculating the burn rate, you need to make sure you check out more figures than one month’s financial information, especially if you want to ensure your calculation is as accurate as possible.
Getting a bigger picture can capture all the financial data you want to examine, such as expenditures that do not happen every month, and ensure your results are not biased based on an excellent or poor month.
Burn Rate Calculation Example
To see how this burn rate calculation applies in real life, consider the following example:
The company is trying to determine its burn rate for the first quarter. As a result, the company will need to look at its cash balance on the first day of the quarter, which would be January 1, and on the last day of the quarter, which would be March 31. Let’s say the starting balance was $100,000, and the end cash balance was $40,000.
Next, you would need to subtract the ending balance from the beginning cash balance:
$100,000 – $40,000 = $60,000
You would then need to divide the ending balance by the number of months you are reviewing.
$60,000 divided by three months (January through March) = $20,000
Consequently, the company’s burn rate would be $20,000 per month.
How Do You Recalculate During a Downturn?
It may be a good idea to update your burn rate during a downturn, which would mean recalculating this rate. It would also be a good idea to measure your cash runway, which is an equation used to figure out how long your capital will continue at the current cash burn rate. The greater your cash runway is, the more likely your business will make it through an economic downturn.
Consequently, the first thing you need to do before completing these calculations is to make sure your books are updated, as this is the only way to know precisely how much cash you have, the number of liabilities and assets you are dealing with, and ultimately, how well your company is doing. If these books are inaccurate, you will not be able to calculate the burn rate accurately, which can impact your financial decisions when it matters most, such as in a downturn.
Calculating Cash Runway
To determine how long you can continue to run your business on your current cash reserves, you will need to use the following formula:
Your Current Cash divided by Monthly Burn Rate = Cash Runway
To see this calculation in action, let’s refer to our previous figures:
$40,000 (the ending cash balance) divided by $20,000 (the monthly burn rate) = 2 (runway)
Based on this equation, if everything else remains the same and the business continues to operate as it is doing, then the company will only have enough capital to run for an additional two months before it exhausts all of its money.
What Can You Do With This Insight?
Calculating these new figures is a great way to figure out not only how well your business is doing but what actions you should take next to ensure your business gets through times of recession, a downturn in sales, or when the company is experiencing a time of slow collections.
Furthermore, this rate will also provide you and your business with significant insight, whether you are a brand new startup or a long-running business looking for more information regarding the company. By being able to have a solid grasp of the burn rate and the cash runway figures, you and your company can have a better understanding of how to spend your capital, how to forecast your future financials, how to make decisions regarding the business, and when to turn to investors for help.
Update Your Books Today With Knowledgeable and Experienced Help
As you can see, having your books updated and your finances in order is key to your overall success. However, this task can be daunting for many new companies. Fortunately, with hiline, it does not need to be.
At hiline, we provide finance, tax, human resources, payroll, and outsourced bookkeeping services for influencers, startups, and other growing businesses. We can even offer you the services of a fractional CFO to ensure your finances are in order and you have a better grasp of the in-depth financial guidance you need.
Just remember good accounting matters a lot, especially during an economic downturn. Do not deal with these critical calculations and bookkeeping on your own. Instead, contact hiline today to learn how our professionals can help you succeed.
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