Gross burn and net burn each contribute to a company’s understanding of one of the most important questions in business:
How long can the company keep earning and spending cash at this rate before it runs dry?
Burn rates reflect how quickly an organization is “burning through” its cash. There are two types of burn rates: gross burn and net burn. A company’s gross burn is the total amount of expenses incurred each month. A company’s net burn is the total amount of money a company loses each month.
Essentially, gross burn rate is equal to all of a company’s outgoing cash and net burn rate is the difference between outgoing cash and incoming cash. A healthy net burn rate is negative as it shows that a company has more cash coming in than it is spending each period.
- How to use burn rates
- Calculating burn rates and runway
- Improving burn rate
- Conclusion: feel the burn
How to Use Burn Rates
Companies use burn rates to make strategic decisions regarding the future state of the business. Evaluating burn rates helps organizations understand their overall financial performance and what the outlook is for each upcoming period. It also helps determine a company’s runway, the amount of time the company can continue on its set path of spending and income before funds deplete entirely.
Companies look to their runway and burn rates to decide what changes are necessary in the business strategy in order to keep the doors open. For example, if an organization shows that, without any change, they will run out of funds in six months, the company can react and make appropriate changes. This could mean putting off unnecessary expenses or rebalancing funds to allow for more aggressive and targeting marketing strategies in attempts to grow revenue.
Calculating Burn Rates and Runway
Net or Gross Burn Rate: Which is Better?
Each metric can provide valuable insight into the future state of a business, but which is better? Should companies focus on gross burn or net burn? It’s best to evaluate both.
Gross burn provides the entire picture for organizational spending. It equals the entire amount of cash that is outgoing in a given period. This is a great metric to use when trying to understand the total expense that is incurred by the business and how much cash is required to keep the doors open if the company loses every revenue source. Gross burn is useful because it’s more predictable in that it doesn’t fluctuate based on any other factor other than how much the company is spending.
On the other hand, the net burn rate can vary based on revenue and collections each period since it takes incoming cash into consideration. Organizations need to use caution when evaluating this metric as favorable months can greatly skew the result. If incoming cash spikes based on positive revenue or collections figures, the net burn will appear more favorable. It may be best not to live and breathe by that figure, however, if it isn’t likely to be sustainable.
Ice Cold Burn
Consider a seasonal business, such as an ice cream parlor in a tourist town. Each month, whether in the busy season or slow season, the parlor incurs fixed expenses just to keep the doors open like building costs, website expenses, and utilities. During the busy season, the business incurs a lot of other expenses related to the increased traffic. They purchase ice cream more frequently and likely hire additional staff to help serve customers. However, the additional revenue likely outshines the added expenses.
The gross burn rate for this ice cream parlor is likely to be lower in the offseason because the business isn’t spending as much on supplies or staff. However, gross burn will increase rapidly once the busier season hits and expenses grow. This is where the net burn rate can provide better insight. It takes income into consideration and since revenue is also expected to increase during the busier season, it can create a more reliable number to follow when planning for the future.
However, since the net burn rate is likely to look favorable during the busy season, it can instill a false sense of security. The business may be tempted to act based on that number and spend a higher amount of cash. Objectively speaking, that may not be a great business decision as their cash is projected to decrease once the peak season fades. Instead, companies should take both numbers into consideration and understand how each can contribute in their overall spending strategy.
Improving the Burn Rate
Keeping the burn rates in check can help make sure the business continues operating for years to come. Companies that regularly evaluate their net burn and gross burn rates alongside their runway can react much quicker to foreseeable cash constraints. What happens when the burn rate isn’t quite where the company would like it to be? Consider the following ways to help get it back on track:
- Cut expenses. Improving the burn rate comes down to making sure expenses stay lower than revenue. Review outgoing cash to find any unnecessary costs that are eating up cash and not adding significant value to the organization. Consider eliminating unused subscriptions or services that can easily be done in-house to conserve funds.
- Avoid overspending during high revenue months. When revenue goes up for a few months, the net burn rate can improve significantly and tempt businesses into spending more cash. Thoughts of expansions and upgrades can fill the heads of leadership but if revenue takes a dive, the business could be in a world of hurt. Instead, businesses should try not to overspend on favorable months and aim to conserve cash for months where revenue dips.
- Ramp up advertising efforts. Evaluate the budget and determine what could be adjusted to accommodate extra marketing and advertising strategies. Assess which tactics work well for your company or industry and decide to increase them in hopes of bringing in additional revenue.
- Analyze trends. Don’t get stuck on these metrics on a month-by-month basis. Instead, take an analytical approach to determine how the burn rates ebb and flow throughout the year. Take note of any patterns so the business can be financially prepared for whatever the future is likely to hold.
Feel the Burn
Don’t fear the burn – embrace it! Both net and gross burn rates help businesses stay on track and prepare for their financial future. Using these metrics, a company can easily determine how long they can keep up with their current spending behavior before funds dry up. Feeling the burn? Take some steps to improve the metric and keep the company moving in the right direction.