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In simple terms, Cash Burn rate is how quickly the company the cash spends cash due to negative cash flows. But we need to understand it deeply.
In this article, we will go through the meaning of burn rate, when it happens, how it is being calculated and more.
What is Cash Burn Rate?
The rate at which the cash is being burnt by a company is called the cash burn rate.
Now why it’s important?
Burn rate isn’t very critical in the case of companies that are doing quite well.
However, for the companies that have just got started and don’t have many sales yet, understanding the cash burn rate is important.
Burn rate is applicable specifically to those companies whose cash flows are running on a negative (not positive).
By calculating the cash burn rate, the companies who are running negative on cash flow would understand how long they would be sustainable. That means burn rate is the measure of the sustainability of a company. On the basis of the cash burn rate, the financing options of a company will be decided upon.
When we look at the graph above, we note that Snap’s Inc share prices have declined close to 40% from its IPO price of $24.48 to $15.15 (currently). This is primarily due to very high burn rate and missed revenue targets. We will look at how Snap’s cash burn rate is calculated later in the post.
Why is cash burn rate important for the investors?
There’s another reason for which the burn rate is important.
Yes, if you’re a start-up, the investors may be having a glance at you. Guess what they’re calculating? You’re right. They are ascertaining the burn rate of your start-up.
The investors look at two factors to come to a conclusion regarding the burn rate.
First, they look at the company’s revenue. And then, they find out the forecast.
If the revenues of the company are growing as rapidly as per the forecast or more, the investors decide to invest in the company.
And if not, then they look at other start-ups for right opportunities.
So, while looking at your burn rate, two things you should always keep in mind –
- Your sustainability is greatly decided by the burn rate. If the cash is burning more rapidly than the revenues, then your sustainability is at stake.
- Secondly, the investors are always at a look out for your start-up and how it has been performing. So, you need to take steps to take care of the burn rate to attract right investors to your company.
But how to calculate cash burn rate?
Cash Burn Rate Calculation
Cash burn rate Calculation is quite easy.
All you need to do is to take two simple steps.
Cash Burn Rate Calculation – Step 1
In the first step, you need to zone in the period of time during which you will calculate cash burn rate.
For example, let’s say that you want to know the cash burn of your start-up during the first quarter (i.e. January to March). Then, you need to look at the opening cash balance at the beginning of the time and at the closing balance at the end of the period. In our example, we would look at the opening cash balance on 1st January. And we will also look at the end balance on 31st March.
- Let’s say that on 1st January, the cash balance is $20,000.
- And at the end of the period, the cash balance is $11,000.
That means during these three months, you burned cash of = ($20,000 – $11,000) = $9000.
Cash Burn Rate Calculation – Step 2
Now you need to take the second step.
All you need to do is to divide the difference between the opening balance and the ending balance by the number of months.
- In our example, the number of months for the period is 3 months. And the difference is $9000.
- That means the cash burn for the period of the start-up would be = ($9000 / 3) = $3000.
Relevance of revenues in Cash Burn
How would you understand whether the cash burn rate is low or high?
There comes the relevance of revenues. Once you calculate cash burn rate, you need to look at your sales.
Are your sales more than your burn rate? In our example, the sales of the start-up for the period should at least be $3000 or more. Otherwise, it isn’t a good position to be in.
Now, let’s take a practical example to calculate cash burn rate and illustrate this.
Cash Burn Rate Example
Ding Dong Inc. is a start-up company. It is aiming for venture capital funding. Thus it wants to look at its cash burn rate for the last quarter of the year. Here is the following information given for computing the cash burn rate –
- Cash flow at the beginning of the quarter – $45,000.
- Cash flow at the ending of the quarter – $15,000.
Since the business has been dry, Ding Dong’s sales for the quarter were just $30,000. Is it enough for the start-up company to remain sustainable? Compare it with the cash burn.
This is a simple example.
All we need to do is to follow the step by step process to first ascertain the cash burn rate and then we will compare with the sales.
The first step is to compute the difference between the beginning cash balance and the ending cash balance of the last quarter of the year.
The difference is = ($45,000 – $15,000) = $30,000.
Now we need to divide the difference with the number of months in the period to find out the burn rate.
The cash burn of Ding Dong during the last quarter of the year is = ($30,000 / 3) = $10,000.
It has been mentioned that the cash flow for the company was dry during the last quarter. And it could only make revenues of $30,000 during that time. That means the revenue for each month was = ($30,000 / 3) = $10,000 as well.
Since the cash burn is also $10,000, we can easily say that Ding Dong is not in a very good position.
To be able to attract the venture capital funding, it has to improve its sales and its cash flow. It is currently in a situation where the cash burn and the cash inflow are exactly same. That means what the organization has been earning, it’s burning right away.
Calculating Snap Inc Cash Burn Rate
Now that we know how to calculate cash burn rate with examples, let us apply our knowledge in Snap’s example.
In March, Snap Inc raised over $2.6 billion in its IPO giving it an overall valuation of $20 billion!
A significant amount of money raised by Snap Inc was invested in Marketable Securities.
Let us look at Snap’s Cash Postition as of 31st March, 2017
- Cash Position of Snap Inc (March, 2017) = Cash and Cash Equivalents (March, 2017) + Marketable Securities (March, 2017).
- Cash Position of Snap Inc = $1,427,114 + $1,815,442 = $3,242,556
Please note that I am adding marketable securities here as the company has invested a sizable portion of its IPO money in the same. This will help us correctly calculate the Cash Burn Rate.
Snap’s Cash and Cash Equivalent as of September 30, 2017
- Cash Position of Snap Inc (September, 2017) = Cash and Cash Equivalents (September, 2017) + Marketable Securities (September, 2017).
- Cash Position of Snap Inc (September, 2017) = $317,554 + $1,980,514 = $2,298,068
- Cash Burn Rate of Snap Inc in six months (31st March until 30th September 2017) = Cash Position as of 30th September, 2017 – Cash Position as of 31st March.
- Cash burn of Snap Inc in six months (31st March until 30th September 2017) = $2,298,068 – $3,242,556 = -944,488 million
- Cash burn of Snap Inc in one month = -944,488/6 = -157,415
Cash Burn Rate of Snap Inc is $157 million per month!
Cash Burn Rate Video
This has been the guide to Cash Burn Rate, cash burn rate calculation, and examples. You may learn other Corporate Finance Topics here –
- Meaning of Negative Cash Flow
- What is Venture Capital?
- Angel Investment vs Venture Capital
- Time Value of Money or TVM
- Dividend Discount Model or DDM
- FCFF or Free Cash Flows
- NPV vs IRR – Key Differences
- NPV vs XNPV | Top Differences with Excel Examples
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