Much has been written about preparing for financial difficulty and it is worth reading about how to plan for it. But, how do you manage your finances when your budget turns red and your exceed your income? Personally, I’ve found using the cash burn rate calculation to be very useful for planning when you are spending more money than you are making.
Work with entrepreneurs and venture capitalists long enough and you are likely to hear this phrase bandied about. Many entrepreneurs spend years taking losses until they’ve successfully commercialized a product and turn a profit. The cash burn rate helps new businesses figure out how fast they “burn” through their resources. In turn, they are able to plan and better manage its fleeting resources.
Calculating Your Cash Burn Rate
What is your cash burn rate?
It is the average amount of money you lose in a certain time period, usually monthly. To calculate your cash burn rate you add up all of your sources of income in a month and subtract by all your expenses in a month. This calculation will determine your negative cash flow each month. If you have a few months of negative cash flow, you can make an average.
How is Cash Burn Rate Useful?
Entrepreneurs use the cash burn rate to help venture capitalists make investment decisions. However, there are many ways the cash burn rate is useful when it comes to personal finances.
If you have a source of emergency funding like a savings account, 401k or IRA, you can use the rate to figure out how long the funding will last. Entrepreneurs call this the cash zero date. The better you perform with lowering your cash burn rate, the further away the cash zero date will be.
The cash burn rate also works in conjunction with your budget. If your budgeting is poor, your burn rate will increase. If you do better than budgeted, your burn rate will drop.
The rate also sets a single target for your income and expenses. I find focusing on a single number is more motivating than trying to lower a number of categories in a budget.
It will also help you to evaluate other potential sources of funding and when to tap into them. If you have multiple funding options down the road, the cash burn rate will help you figure out when you may need to tap into them and how long they’ll last. There are many options to consider when you are losing money, and the cash burn rate aids in answering important questions. For example, if you lost a job and are searching, at what point would you take a job for less salary? When do you consider a second job?
Cash Burn Rate Versus Budgeting
I know what some readers may be thinking. What’s the point of watching your cash burn rate? It’s essentially the amount of money that exceeds your budget. However, there are a number of reasons why tracking your cash burn rate is worth the extra effort.
While you may not adjust your budget from month to month, expenses are rarely fixed. In life, there are always surprises and they are often costly. Cars break and houses need repair. As hard as you may try to maintain a level amount of expenses from month to month, unexpected spending will happen. Figuring a cash burn rate will help you to put a single number to the ups and downs of spending each month.
Also, the cash burn rate helps you to measure your money in time. It’s much easier to pass on a lavish expense when you know what day your money runs out and that unnecessary spending will cause that day to come sooner.
When your expenses are more than your income, you need every tool at your disposal. Calculating your cash burn rate will help.
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