How the Burn Rate Is a Key Factor in a Company's Sustainability

"Burn rate" refers to the rate at which a company spends its supply of cash over time. It's the rate of negative cash flow, usually quoted as a monthly rate. In some crises, the burn rate might be measured in weeks or even days. Analysis of cash consumption tells investors whether a company is self-sustaining and signals the need for future financing.

Getting Burned by the Burn Rate

Burn rate is mainly an issue for startup companies that are typically unprofitable in their early stages and are usually in high-growth industries. It may take years for a company to generate profit from its sales or revenue and, as a result, will need an adequate supply of cash on hand to meet expenses. Many technology and biotech companies face years of living on their bank balances.

Burn rates also apply to mature companies that are struggling and carrying excessive debt. Airline stocks, for example, faced a crisis following 9/11, which placed the largest air carriers in a cash crunch threatening the industry. United Airlines, for instance, suffered a daily cash burn of more than $7 million before seeking bankruptcy protection.

If a company's cash burn continues over an extended period, then the company is likely operating on stockholder equity funds and borrowed capital. Investors need to pay close attention to the burn rate of cash, particularly if the company is seeking additional capital.

If companies burn cash too fast, they run the risk of going out of business. On the other hand, if a company burns cash too slowly, it might be a sign that it is not investing in its future and may fall behind the competition. An effective management team knows how to manage cash well.

Calculating a Company's Burn Rate

The burn rate is determined by looking at the cash flow statement, which reports the change in the firm's cash position from one period to the next by accounting for the cash flows from operations, investment activities, and financing activities.

Burn Rate = Total Change in Cash Position Change/Specified Time Period

Compared to the amount of cash a company has on hand, the burn rate gives investors a sense of how much time is left before the company runs out of cash—assuming no change in the burn rate.

Time Before Cash Runs Out = Cash Reserves/Burn Rate

If you want to know if a company is really in trouble, compare its burn rate with the working capital measured over the same period. Working capital is a company's current assets, such as cash, accounts receivables, and inventory, minus its current liabilities, including accounts payables. Working capital is often used as a metric to gauge a company's short-term financial health.

Working Capital / Burn Rate

An Example of the Burn Rate

Let's consider the cash flows of a hypothetical company—Super Biosciences. For starters, the net cash from operating activities was negative $5.75 million for the first nine months of the year. This means the core business operations burned cash at a rate of about $640,000 per month, largely thanks to continued operating losses.

In addition, suppose that Super made some new investments in capital assets. As a result, the net cash flow from investing was also negative, to the tune of about $1.9 million. The net cash burned by operations and investing activities amounted to over $7.65 million—a burn rate of roughly $800,000 per month.

Some analysts argue that a more appropriate way to estimate cash burn is to ignore the cash from investing and financing activities and focus solely on cash from operations. However, that narrowed focus doesn't seem prudent because most firms need to make capital expenditures to continue operating.

So, let's say that Super Biosciences has about $10.8 million in cash at the end of the period. Assuming Super Biosciences' current cash burn rate doesn't ease up, the company will run out of cash in about 13 months—meaning the company's runway is 13 months for a burn rate of $800,000 per month. To improve its cash position and avoid the fate of running out of cash, Super Biosciences can do the following:

• Decrease its burn rate through cost reductions, including layoffs or employee pay cuts.
• Generate additional cash from sales and marketing.
• Invest in research and development by deploying its cash wisely to generate growth.
• Sell company assets.
• Raise external finance by issuing debt or equity.

Of course, the ability to raise more capital can be challenging, especially for startup companies. Executives must take advantage of favorable financing periods and attractive interest rates to improve the company's cash position and access to working capital. If a company plans to raise the needed cash through a share issue or initial public offering, it needs to plan since the process of issuing additional equity can take six months or more.

The Bottom Line

When investor enthusiasm is high, unprofitable companies can finance cash burn by issuing new equity shares, and shareholders might be happy to cover the cash burn as in the case of the dotcom bubble in the late 1990s. However, when the excitement wanes, companies need to demonstrate profitability, and if they don't, they can be at the mercy of the credit markets.

As a result, a company with a high burn rate can find itself scurrying for cash from banks or creditors and get trapped into accepting unfavorable financing terms, be forced to merge, or even go bankrupt. It's important for investors to monitor a company's available cash, capital expenditures, and cash flow burn rate before deciding to invest.