Burn Rate

Burn rate definition

In economics, the accepted burn rate definition is the speed at which a company expends venture capital to support its operating overhead. Also known as the cash burn rate , it is essentially a measurement of negative cash flow calculated on a monthly basis. Companies with high operating expenditures have higher burn rates than more economically-run companies, and typically require higher revenues in order to continue operations. Burn rates are often predictive of a company’s future need for cash infusions or cutbacks in overhead expenses. An accurate calculation of the burn rate can offer an assessment tool for start-ups and companies in financial distress, allowing an accurate indication of the company’s likely lifespan if it does not achieve positive cash flow.

Burn rate calculation 

The burn rate is calculated by dividing the outflow of cash from the company’s coffers by the time period in months of that outflow. The formula may be expressed as:

• Total Expenditures / Time = Burn Rate

If a company expects to spend $10,000 over the next ten months, its burn rate can be derived by taking $10,000/10, arriving at a burn rate of $1,000. This formula is then used to derive a financial prediction about the company’s long-term viability and how soon the company’s operating costs will necessitate acquiring new debt, issuing stock, or making cutbacks in staff or operating expenses. The predictive formula is expressed thusly:

• Cash on Hand / Burn Rate = Months Remaining Before Out-of-Cash Date

Using the previous example, if the company in question has $5,000 in ready cash on hand, then by applying the predictive formula and dividing $5,000 by the burn rate of $1,000, the formula predicts that the company has only five months left before it is out of cash unless new sources of financing or revenues are found.

For most profitable companies, revenues outstrip the burn rate by a comfortable margin. For start-up companies and those in financial crisis, however, the burn rate and predictive formula can provide a crucial timeline indicating how long the company will remain viable under current conditions. If the company does not achieve a positive cash flow, it will have to take out new debt, sell more stock, or cut back its operations. Each of these options lessen the likelihood of profitability in the future and generally cause a further devaluation of stock and lower credit ratings for the company in question.

Each share of a company’s stock is essentially a fraction of the value of the company as a whole. Therefore, while making an additional stock offering may seem a good way for a company to gain additional funds for expansion and to defray a high burn rate, it lowers the value of all shares of the company; more shares sold mean less value attaches to each individual share.

Many financial analysts blame the crash of the dot-com industry on excessive burn rates and overly optimistic predictions of when positive cash flow would be achieved. Typically, dot-com companies were financed by incurring debt and selling stocks in multiple stages and spending huge sums of money in overhead to achieve potential profits which, in many cases, never materialized. Because investors misinterpreted the high burn rate of these companies as indicative of a fast-growing customer base, many shareholders ignored the falling value of their stocks and continued to invest in companies with little chance of survival.
Tim Ord
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