KNOW YOUR COMPANY’S CAPITAL BURN RATE
“It is imperative that your business be operated in accordance with a realistic budget that provides for coverage, in full, of your monthly capital ‘burn rate’.” – Douglas E. Castle
The basic definition of Burn Rate (from the ever-notable and perpetually-edited Wikipedia) is as set forth below:
Burn rate is a synonymous term for negative cash flow. It is a measure for how fast a company will use up its shareholder capital. If the shareholder capital is exhausted, the company will either have to start making a profit, find additional funding, or close down.
The term came into common use during the dot-com era when many start-up companies went through several stages of funding before emerging into profitability and positive cash flows and thus becoming self-sustainable (or, as for the majority, failing to find additional funding and sustainable business models and thus going bankrupt). In between funding events, burn rate becomes an important management measure, since together with the available funds, it provides a time measure to when the next funding event needs to take place.
Some entrepreneurs and investors say that part of the reasons behind the dot-com bust was the unsound management and financial investor practices to keep the burn rate up, taking it as a proxy for how fast the start-up company was acquiring a customer base.
The term burn rate can also refer to how quickly individuals spend their money, particularly their discretionary income. For example, Mackenzie Investments commissioned a test to gauge the spending and saving behavior of Canadians to determine if they are “Overspenders.”
Aside from financing, the term burn rate is also used in project management to determine the rate at which hours (allocated to a project) are being used, to identify when work is going out of scope, or when efficiencies are being lost. Simply put, the burn rate of any project is the rate at which the project budget is being burned (spent).
In earned value management, burn rate is calculated via the formula, 1/CPI, where CPI stands for Cost Performance Index, which is equal to Earned Value / Actual Cost.
Perhaps a better working business definition of “Burn Rate” can be found in the august annals of Investopedia, an excellent resource for business definitions:
DEFINITION of ‘Burn Rate’
The rate at which a new company uses up its venture capital to finance overhead before generating positive cash flow from operations. In other words, it’s a measure of negative cash flow.
INVESTOPEDIA EXPLAINS ‘Burn Rate’
Burn rate is usually quoted in terms of cash spent per month. For example, a burn rate of 1 million would mean the company is spending 1 million per month. When the burn rate begins to exceed forecasts, or revenue fails to meet expectations, the usual recourse is to reduce the burn rate (which, in most companies, means reducing staff).
Sadly, neither of these protracted and elaborate definitions show us the true utility for knowing your company’s burn rate. According to the Douglas E. Castle explanation, “Burn Rate” means at least two different things and has several highly useful computations attached to it.
Firstly, your company’s Maximum Capital Burn Rate is the amount of money which you have available to spend per month over a given time frame in order to accomplish financial self-sufficiency or some other objective.
The perfect example would be in the case of a newly capitalized enterprise that had acquired $1,000,000.00 [this number was chosen arbitrarily] and had establish an 18-month time frame in order to be actively engaged in commerce at a profit with its new product. In this case, the Capital Burn Rate would be equal to the capital infused, divided by 18 months, or a Capital Burn Rate (actually “Maximum Capital Burn Rate”) of $55,555.56 per month.
Looking at this same situation in reverse, suppose the company’s management knew that it required $30,000.00 per month in order to sustain itself. It could then calculate its Capital Life Expectancy by dividing $1,000,000.00 by $30,000.00, or 33.33 months, after which the capital would have run out.
Secondly, your company’s Operating Burn Rate is simply the monthly fixed costs (in the aggregate) required in order to keep the company operating without incurring a loss. If your Operating Burn Rate ( based upon experience) were $20,000.00 per month and your company’s liquidity were a declining $1,000,000.00, your company’s Operating Life Expectancy would be $1,000,000.00 divided by $20,000.00, or 50 months.
The only way to reduce Burn Rate is to reduce or eliminate unproductive fixed costs.
Tags, Labels, Keywords, Categories And Search Terms For This Article:
Maximum Capital Burn Rate, Operating Burn Rate, Operating Life Expectancy, Business, Finance, Capitalization, Fixed Costs, Breakeven Analysis, Douglas E. Castle
NOTE: THE INFORMATION CONTAINED IN THIS ARTICLE SHOULD NOT BE CONSTRUED BY THE READER AS BEING LEGAL, FINANCIAL, TAX, ACCOUNTING, ECONOMIC OR INVESTMENT ADVICE. NO OFFERING OF SECURITIES OR OTHER INVESTMENT INTERESTS OF ANY TYPE IN ANY ENTITY IS MADE HEREBY, NOR IS A SOLICITATION FOR THE PURCHASE OF SECURITIES OR OTHER INVESTMENT INTERESTS OF ANY TYPE IN ANY ENTITY MADE HEREBY. THIS ARTICLE IS INTENDED FOR GENERAL INFORMATIONAL PURPOSES ONLY AND REPRESENTS THE VIEW OF THE AUTHOR ONLY.
THIS ARTICLE IS COPYRIGHT 2014 BY DOUGLAS E. CASTLE, WITH ALL RIGHTS RESERVED. ANY REPRODUCTION, TRANSMITTAL OR DISTRIBUTION OF THIS ARTICLE, EITHER IN WHOLE OR PART, IS UNAUTHORIZED AND MAY BE UNLAWFUL, UNLESS FULL ATTRIBUTION IS GIVEN TO THE AUTHOR AND ALL IMAGES AND LINKS IN THE ARTICLE REMAIN INCLUDED AND “LIVE.”
- Founders, quick, what is your burn rate? (startupmuse.com)
- Lessons Learned from Heavy Startups (davidcummings.org)
- Burn Rates Post & Second Seed Announcement Enter My Top 10 All Time Blog Posts List (daniellemorrill.com)
- Cuomo spent almost $8M in final stretch (timesunion.com)
- VC Points Out That VCs Might Have A Burn Rate Problem Of Their Own (techcrunch.com)
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