As a small business owner, you likely started your company because of your passion and expertise for the products and services you provide—not because of your passion for financial statements. For this reason, critical financial metrics often go unnoticed by business owners. One of the most common examples is burn rate.

Burn rate is one of the most important factors in your small business financial health, especially early on. It is a direct indicator of whether or not the business will face cash flow issues in the future. Small business owners should understand how to calculate burn rate, and what it means for their business.

What is burn rate?

Early-stage small businesses (startups in particular) are often unable to generate positive income, so they need to budget the rate at which they burn through capital. The burn rate is exactly that—the amount of money it takes for a business to cover all of its expenses (usually measured by month).

For startups, this is a critical factor because it will show the length of the company’s cash runway. In other words, it shows how long before the company runs out of money. Knowing your burn rate will help you anticipate the need to seek more funding, or provide a timeline for when the company must become cash flow positive.

Burn rate is an evaluation metric for potential investors as well. It indicates risk and likelihood of a company turning a profit before the investment runs out. Lower burn rates are often more attractive to investors because the company has more time to become profitable.

But it’s not just a metric for startups. Outside factors can temporarily impact long-standing, successful businesses for a quarter or a year. Any company can have a bad quarter. Cash flow issues can impact even profitable companies if they do not manage their burn rate. Outside factors can temporarily impact successful businesses. Look no further than the effects of the pandemic or the recent surge of inflation in the US. Businesses in strong cash positions will be better equipped to withstand a poor stretch.

How to calculate burn rate

Before we dive into a burn rate formula and financial balance sheets, let’s return to our original premise: most small business owners are not finance experts by trade. With that in mind, the easiest way to calculate and track your burn rate is automatically through a connected financial management system. (Maybe even a free one).

Although it’s not necessary to manually calculate your burn rate, understanding what it is will put you in a better position to improve it. So let’s look at a basic formula:

Monthly burn rate = (Starting cash – Ending cash) / X number of months

For example, let’s say you want to calculate your monthly burn rate over the last six months. Your business started the period with $250,000 and finished with $70,000 on hand.

Subtract the $70,000 from the original $250,000, and you’ve burned $180,000. Divide that by six months, and your monthly burn rate is $30,000 over that six month period of time.

What is gross burn rate?

The formula above is a standard burn rate formula that will help any small business owner manage their cash flow. There is a variation of burn rate that isolates a company’s expense patterns and impact on cash (without factoring in income performance). This is called gross burn rate. Gross burn rate is determined by dividing total cash by operating expenses over a period of time. It removes the revenue variable from the equation, showing only what the company spends.

Why would you measure gross burn rate?

The simple answer is that “cash in” is a variable. Small businesses have strong revenue months and poor revenue months—even very successful ones. While revenue is obviously a central factor in the health of a business, removing it from the equation will reveal a company’s spending trends. An outlier month or quarter in revenue can skew the company’s net burn rate either way. Removing this variable in gross burn rate will provide a better indication of how quickly a company is spending its cash.

How to improve your burn rate

Decreasing your burn rate will give your company a longer cash runway toward profitability. If your company is already profitable, it will help your small business withstand negative outliers in sales and revenue.

Here are a few ways to improve:

Decrease expenses

Unused subscriptions, bad contracts with vendors, and inefficient spending in marketing can all significantly increase your burn rate. Audit your expense statements for technology spending. Track your marketing and advertising spends to business goals, and reconsider anything that doesn’t contribute. Renegotiate vendor contracts if you’re no longer using the vendor for the original scope of the relationship. Try to ensure your small business is always getting the best deal.

Connect your business bank accounts to a financial system that audits and categorizes your spending, alerting you of duplicate transactions, unusual expenses, and opportunities to save in specific spending categories.

Practice income management

Expenses are a natural place to turn, but optimizing your income is often a better opportunity to improve. Trimming expenses in the wrong places can cost your small business, but there’s never a downside to getting paid faster. For starters, be sure your company invoices properly and has an efficient process for collections. Consider financing your invoices or recurring revenue for a cash influx on the money you’ve already earned.

Small business owners pour their hearts and souls into their products, services, and sales. Unfortunately, they don’t always get paid immediately, which can have severe consequences for their company’s cash flow.

Refinance your debt

Business expenses are not the only factor working against your runway. Debt and interest will constantly suck cash from your business, so always look for opportunities to refinance. There are often windows of opportunity where business owners can anticipate rising interest rates and get ahead of it.

If these are new concepts to you as a small business owner, start by simply tracking your net burn rate month over month. Implement the suggestion above, and track how changes reduce it. There will be short term benefits and long term foundational strength for your business to navigate all of the things the world will throw at you in the future.