As a startup looking for investment or an eCommerce business seeking financing, you will often be asked what your business burn rate is. Burn rate is the main variable for calculating your 'runway' - the amount of time your business can operate before it has to seek for additional funding.
As a founder, it is extremely important to know how long your company can operate before it runs out of cash, and when is the right time to put your energy and time into finding financing.
In this blog, we will explain what burn rate and runway are and how to calculate them.
What Is 'Burn Rate'?
A company's burn rate is the rate at which the company burns through its finances. The rate is typically calculated as the cash a startup spends every month. The burn rate can be referred to in gross or net.
Gross Burn Rate
The gross burn rate is simply the amount of cash you spend in a single month. It does not take into account how much cash comes into the business during the month. For example, if the company spends $100,000 in a certain month, its gross burn rate for that month is $100,000.
Net Burn Rate
The net burn rate takes into consideration how much money comes in and comes out of the business during the month. The net burn rate is calculated by subtracting the total cash spending during the month from the monthly net revenue. For example, if the company spends $100,000 in a certain month, and had $70,000 in net revenues (gross revenue minus returns, refunds and discounts), its net burn rate for that month is $30,000.
It is important to note that net burn rate does not take into account funds injected into the company, which do not constitute revenue. For example, cash received as an equity investment or a loan.
Investors and lenders will typically ask for your net burn rate. The net burn rate accurately reflects for how long the company can operate with the level of cash it currently has. Although most investors and lenders focus on the net burn rate, the gross burn rate is still an important factor when looking at a business with an unstable or vulnerable revenue streamline (for example, if a startup company focusing on R&D has only a few customers, or where the customers are mostly distressed companies)
Average Burn Rate
The company's average burn rate is calculated as the total burn rate in a certain period, divided by the number of months in that period. The typical periods for calculating the average burn rate are 6 months and 12 months.
For calculating the burn rate, you need to know your company's level of spending in a certain month and its net earnings (for calculating the net burn rate). This is why you need good bookkeeping and accounting procedures and records.
The cash flow statement can give you an indication of how much cash your company currently spends a month. The profit and loss statement (P&L) can also be used for that, but only to the extent you manage your books pursuant to the cash method of accounting (as an eCommerce brand or a startup company, this is unlikely though). From there, you can compute your current burn rate and build up a spending and earning forecast for the future.
It becomes helpful and even necessary to have available cash flow and P&L statements for easily calculating the burn rate and providing information to your investors and lenders.
What Is 'Runway'?
Simply put, the runway is the amount of time your company has until it runs out of money. Effectively, it looks at how long until your company "burns" through its funds. The runway is calculated by diving the total cash the company currently has by the average burn rate. For example, if you have an average burn rate of $10,000 and total cash of $200,000, your eCommerce business can operate for the next 20 months without an additional investment or financing.
Note that some takes an approach that the runway should reflect not only the cash at hand, but also the company's receivables and payables.
The company's runway is a signal of how quickly additional funding should be raised and the level of risk of the company. The runway is also an indicator of the level funding the company currently needs.
What Is the Right Burn Rate for An eCommerce Brand?
The answer depends on the level of financing you have raised so far, your revenue growth rate and the expected future funding.
Typically, eCommerce brands keep at least 6 months of runway. This period should generally allow a business enough breathing room before looking for additional financing or look for ways to dramatically lower burn rate. The maximum recommended net burn-rate is calculated by dividing the cash the company currently has by 6.
However, if the monthly growth rate in revenues your brand expects is greater than the expected monthly growth in spend, your brand should have longer runway which supports increased burn-rate.
As an eCommerce or a startup founder, you should be mindful of keeping your startup operational with some safeguards. You should always track your finances in general, and your burn-rate and runway, in particular. While doing so, you should take into consideration the specific circumstances of your company and the industry in which it operates. Knowing your burn-rate and runway can help you manage your company's expenses effectively, and seek for funding at the right time and at the right level.
It is highly recommended to maintain accurate Cash-Flow and P&L statements, such that you base your business decisions on solid, relevant and reliable data.
If you are still behind with your bookkeeping, contact Finaloop today to get back on track.