The Cash Burn Rate - An important indicator for startups.

"Cash is king" - everyone has heard this phrase. However, it is not just an empty phrase, but actually has an important meaning in a business context, because without liquid funds, companies quickly face insolvency. Especially for startups, "cash is king" is an important guiding principle. Startups usually have little or no income and therefore need to manage their available financial resources well in order to cover essential costs.

As the founder of a startup, it is important to know when you are running out of money so that you can react in time to either raise new capital or cut costs. To determine this point, the cash burn rate (CBR) is an important indicator.

In this blog article, you will learn what the cash burn rate is, how it is calculated, how it can be optimized, and why the term is often misused.

What is the cash burn rate?

The cash burn rate is an important financial indicator for businesses. It is a metric that shows how quickly your startup is using the capital available to cover operating expenses.

Specifically, it is the amount of money your startup uses per accounting period (days, weeks, months, years).

If the CBR has been calculated, this will help you to determine the time when the financial resources have been used up and insolvency is therefore imminent.

This period of time, referred to below as time until insolvency, is often equated with the CBR. This is problematic because it results in two different interpretations of a high or low CBR.

If the CBR is meant as an amount of money that is being used per accounting period, then a high CBR is to be interpreted as bad. If, on the other hand, the time period until the startup faces insolvency is meant, then a high CBR is a positive signal.

However, the fact that a high CBR is a positive signal contradicts the intuitive understanding of a rate and can lead to confusion. This is particularly unfavorable when talking to potential investors. We therefore advise you not to equate the CBR with the time until insolvency in order to avoid misunderstandings.

Significance of high and low CBRs

A company with a high CBR consumes its financial resources faster than it generates revenue. This is particularly common with startups because they make high investments in technology, staff and other resources to develop their business.

A low CBR means that the company is using up its cash relatively slowly, which is favorable as it has more time to implement its business plans and become profitable. It also means that you are able to make smaller investments with your existing financial resources.

For larger investments, it is important to consider how you can release committed capital to generate more liquidity. Alternatively, you can take out a loan or approach private investors who would like to invest in your startup.

Gross or net

The cash burn rate can be viewed in two variants: The gross CBR(gross burn rate) and the net CBR (net burn rate).

The gross CBR indicates how quickly your startup is spending money by looking at the amount of operating expenses and investments during a certain period of time.

The net CBR, on the other hand, takes into account both the expenses and the income in order to determine how quickly the losses increase.

Indicator for startups

As a founder, you should always keep an eye on the consumption of your financial resources. This allows you to take timely measures to reduce costs or find additional sources of funding to secure your liquidity.

In summary, the cash burn rate is an essential indicator for startups to monitor the consumption of financial resources. Effective control of the CBR can help you to ensure the long-term survival and success of your company.

For whom is the cash burn rate important?

In addition to the above-mentioned relevance for founders of startups, the CBR is particularly important for investors and venture capitalists who want to or are planning to invest in your startup. They want to ensure that their investment is being used efficiently and that the company has sufficient financial resources to achieve its business goals. Often, determining the CBR is part of the due diligence. By keeping an eye on the CBR, investors can get an idea of the financial condition of your startup.

As startups are often dependent on external financing through venture capital, it is an advantage to have a low cash burn rate. This shows that you can handle capital responsibly and thus gain the trust of potential investors.

Overall, the cash burn rate plays a significant role for startups, investors and venture capitalists. For this reason, it is important to regularly identify this financial instrument and, if necessary, take measures to adjust the CBR. However, the CBR should not be confused with the loss, which is determined in the income statement and is a different indicator.

What factors are included in the calculation of the cash burn rate?

Cash and cash equivalents

Cash and cash equivalents represent the liquid assets at your startup's disposal for immediate use in the short term. This contrasts with the capital tied up in fixed assets, as cash and cash equivalents must be readily convertible into liquid funds before they can be deployed for immediate investments. These easily accessible funds encompass cash on hand and the balance in your business account, offering you the flexibility to directly utilize them for your investment needs.

Negative operating cash flow

Operating cash flow is a key business figure used to analyze available liquidity. To determine cash flow, all revenues and expenses are compared over a specified accounting period. This accounting period can be a month or a year. If you spent more money than you took in during a period, you have a negative cash flow.

Formula for calculating the cash burn rate of your startup

To calculate the CBR of your startup, you need the following formula:

CBR = negative operating cash flow / cash and cash equivalents

You may be wondering where you get these numbers from - don't worry, we'll explain it to you step by step:

1. Cash and cash equivalents: This includes cash, bank balances and other short-term funds. A look at your balance sheet or asking your tax advisor can help you determine this value.
2. Negative operating cash flow: This is the negative amount of operating income and expenses within a certain period. This value can typically be taken from the income statement (profit and loss account).

Calculation example for CBR

Let's assume you have €50,000 in liquid funds and a monthly negative operating cash flow of €5,000.

The calculation of the CBR using the formula is as follows:

CBR = 5,000 / 50,000 = 0.1

The lower the result of the calculation, the better the financial situation of your startup.

Calculation example for time until insolvency

This calculation can also be used to determine how long the time until insolvency of your startup is by dividing 1 by the CBR. It is important to note which accounting period was used to calculate the CBR (days, weeks, months, years). Only then can the result be interpreted correctly.

Time until insolvency = 1 / CBR

In this case, the result is:

Time until insolvency = 1 / 0.1 = 10 months

This means that with the current expenditure and income situation, it would take 10 months until your liquid financial resources are completely used up.

How can a startup reduce its cash burn rate?

Determination of essential expenses

First, you should identify the essential expenses. Distinguish between fixed and variable costs. Fixed costs are, for example, rent,  salaries and  software licenses. Variable costs are dependent on the production quantity, such as material costs or shipping costs. Analyze these expenses and make sure that they are essential to the business model.

Reduce irrelevant costs

To increase the survival time, you should reduce irrelevant costs. These include expenses that do not directly contribute to the success of the company. Examples of this are excessive office space or unnecessary travel.

Renegotiating contracts

Another measure  is the renegotiation of contracts. Contact your suppliers and negotiate better conditions. Negotiating rental contracts for software licenses can also lead to savings.

Performance-related salaries

Introducing performance-related salaries can help to extend the time until insolvency. Set targets for your employees and offer them salary increases or bonuses based on their achievement. This can make them more efficient and motivated and help you get a better grip on your expenses.

Business Model Pivot

In some cases, it may be necessary to rethink and adjust the business model. A pivot might focus on a different customer segment or a different type of product or service. This change opens up new opportunities to increase efficiency and reduce costs.

Conclusion

The cash burn rate is a key metric for startups looking to assess their financial health and liquidity. It provides information about how quickly available financial resources are used to cover operating expenses and is therefore an indicator of a company's ability to survive.

A low CBR indicates that a startup is able to use its financial resources in the long term, while a high CBR indicates possible financial bottlenecks. Regular monitoring and, if necessary, adjustment of this ratio is crucial to ensure financial stability and long-term success.

Frequently asked questions

How do you calculate the cash burn rate?

The CBR is calculated by dividing the company's negative operating cash flow by the cash and cash equivalents. This calculation results in a figure that indicates how high the share of expenditure is in the available financial resources. The time until insolvency of the startup can also be derived from this figure.

What does the cash burn rate mean for startups?

The CBR is important for startups because it provides information about the financial health of the company. A High CBR means that the company is using up its available capital quickly to cover running costs, while a low CBR indicates that the company is operating more efficiently and can work longer with its existing resources.

Why should the cash burn rate be reduced?

Lowering the CBR gives you as a founder mainly one advantage - more time. Because your startup can survive longer with the available funds, you have more time to make optimizations or important decisions. This gives you a greater chance of increasing profitability, which means your startup can finance itself.

Why is the cash burn rate important for investors?

Investors pay attention to CBR as it serves as an indicator of a company's financial health and stability. A high CBR can serve as a warning signal that a company may be struggling to cover its costs or achieve its business goals. Investors typically look for companies with a low CBR as this indicates a more efficiently run company and lower risk.

What role does the cash burn rate play in financial planning?

The CBR plays an important role in helping you understand how long your business can operate with existing resources and how quickly you need to find new revenue streams or cut costs to increase profitability. This allows you to take action in good time to overcome these difficulties and ensure the continued existence of your company.

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