A company’s “burn rate” is the rate in which it depletes its pool of cash. It often serves as a common metric of performance and valuation for contractors. Many believe the burn rate is a key metric for decision-making, as it provides an accurate picture of a contractor’s financial health.
Luckily, calculating the burn rate is not difficult. The burn rate is the cash that a contractor is spending every month (Burn Rate = Cash balance in the prior month – Cash balance in the current month). In other words, it is the actual amount of cash that decreases in a single month.
While gross burn rate is the amount of cash spent in a single month but does not take total revenue (incoming cash) into account, the net burn rate includes incoming revenue in its calculation. Therefore, the net burn rate helps a contractor understand how much additional revenue they’ll need to break even and how much longer they’ll have until they run out of money if nothing changes.
To find the burn rate for a given month, a contractor should subtract the cash balance for the current month from the previous month’s cash balance. Taking it a step further, they can determine the average burn rate by repeating the process for several months, adding the monthly burn rates together and dividing by the number of months.
Normally, this calculation results in a number equal to zero or slightly above it. Although rare, there are some situations when the burn rate might come back as negative (a contractor is earning more money than they’re spending).
What if a Contractor has a High Burn Rate?
A high burn rate suggests that a company is depleting its cash supply at an unacceptably fast rate. As such, it could indicate a state of financial distress. To reduce the burn rate, contractors should consider the following:
Layoffs and Pay Cuts: Layoffs are often necessary when projects are finished, but the backlog is not being replenished—this requires a leaner strategy. Although this is often a tough decision, it still needs to be considered in lean times. Pay cuts are tougher to manage as they often relate to the workers’ overall morale, and most often are only effective in upper management where the necessity is known.
Capital Expenditures: A company should remember to review its equipment expenditures and leases monthly to determine ongoing needs. Often, pieces of equipment are kept longer than needed due to inefficient project planning.
Growth: A company can project an increase in growth that improves its economies of scale. This kind of growth allows it to cover its fixed expenses to improve its financial situation. For example, many food delivery startups are in a loss-generating scenario.
Marketing: Often, companies invest in marketing to achieve growth in their user base or product use. However, startups are often constrained in that they lack the resources to use paid advertising.
When it comes to burn rate, it’s crucial to know where your company stands and how much money you have coming in to predict performance and valuation accurately. For further guidance, reach out to CRI construction-focused advisor with any questions you may have.