"What is the burn?"
Common question and utterly confusing without context. Burning cash means that the company is still unprofitable and is cash flow negative. The burn refers to the cash leaving the business. Early stage companies are almost expected to experience this for the first few years of business and it is very rare to see a young company growing at a fast pace and maintaining profitability. It is still common to see large growth stage companies and even public companies still burning cash. This is largely due to the level of investment that they are deploying into growth. Regardless of company stage, monitoring cash is vital to the success of a company.
There are two ways to understand the burn rate using different financial statements.
The Balance Sheet approach is a longer term calculation and is calculated by subtracting the cash balance at the end of the year from the cash balance at the beginning of the year. We would simply convert this annualized burn to monthly burn by dividing this figure by 12.
The Income Statement approach is accomplished by calculating Earnings Before Depreciation and Amortization (EBDA). EBDA is calculated by finding the earnings (loss) and removing any depreciation or amortization that may have been included. We understand that interest and taxes are necessary cash expenses and need to be included in our cash burn but depreciation and amortization does not impact cash.
Balance Sheet Approach: (Cash at the Beginning of the Year - Cash at the End of the Year) / 12
Income Statement Approach: Monthly Earnings (aka Net profit/loss) Ignoring Depreciation and Amortization
Awesome. Now we understand burn. This doesn't tell us much on its own. In using the burn, we are able to understand how much gas we have in the tank before we need to raise more capital or become cash flow positive. The best way to accomplish this is calculating months of runway.
We are able to calculate our months of runway by dividing cash by monthly cash burn. The volatility of cash burn in some ventures can make it challenging to rely on this calculation. Therefore, using an average monthly cash burn based on the past 3 months is a better approach.
Months of Runway: Ending Cash Balance / (3 Month Average Cash Burn)
The cash burn and months of runway calculations help operators and investors understand the capital needs of a business. From a fundraising standpoint, a single round of financing should offer 18-24 months of runway. With these tools, operators can calculate the necessary round size.
We all know that we get a few more miles when our gas tank hits empty. For ventures, empty means 6 months of cash. In working with ventures, I have noticed that the best venture-backed management teams have a signed term sheet just before they reach 6 months of remaining runway. This allows management enough time to evaluate deal terms and make the best situation. It seems that mistakes are made and poor deal terms are taken when fundraising starts around the 3 months of cash. Give yourself time and always leave a little in the tank before filling up.
Be smart and understand your cash.