Calculating and Understanding Burn Rate

Burn rate is another way to say, "negative cash flow." It is a measure of how quickly a company moves through money in order to make purchases, pay staff or expand. All companies should have some negative cash flow. They must pay vendors, and wise companies will also spend some profits on capital investments. However, the key is to keep negative cash flow balanced against positive cash flow in order to turn a profit.

Calculating Burn Rate

Burn rate is a simple calculation of how much a business spent in a single month. If the business spent $100,000 in January, its January burn rate is $100,000. The burn rate does not take into account the profit. However, burn rate is often used to describe how quickly a company "burns through" its initial capital before turning a profit. Once the company is profitable, the term negative cash flow generally replaces the term burn rate. At the heart, however, the two are the same thing. 

Measures of Financial Security

Burn rate is one of the key measures of a company's financial security. On any financial report, there will be three critical elements: a balance sheet, an income statement and a cash flow statement. The balance sheet shows a company's assets and liabilities. An income sheet shows its gross earnings in a particular term. Finally, the cash flow statement shows how much income is coming in compared to how much cash is being spent. Only when the income is greater than the outward cash flow, or burn rate, is there a profit.

Burn Rate and Industry

Some industries will have a much higher burn rate than others. For example, if a new company would like to enter the light bulb manufacturing business, the company will need to purchase a plant, equipment, raw materials and pay a large group of employees. This company could have a very high burn rate for five or more years prior to turning a positive cash flow. On the other hand, a small Internet company may only cost $10,000 to set up. The burn rate should be very low, and a positive cash flow may be expected in as little as one year. Whenever you consider investing in or even starting your own company, think about how long you can expect to be operating at a high burn rate prior to actually paying off investors and loans and turning a profit.

Burn Rate and Bankruptcy

Even once a company turns a profit, there is always the potential it could return to a state of high burn rate. This occurs when inbound sales fail to keep pace with company operating expenses. The first step to correcting a problem with high burn rate in this situation is usually a layoff or salary reduction. The next step would be to cut back production in an attempt to reduce overhead. Finally, if a company cannot create positive cash flow through these measures, the company may need to close its doors or sell to another business. Hopefully the company is not in debt. If it is, it may need to declare bankruptcy. 

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