There’s no doubt that money can be made by owning shares of unprofitable businesses. For example, biotech and mining exploration companies often lose money for years before finding success with a new treatment or mineral discovery. But the harsh reality is that very many loss making companies burn through all their cash and go bankrupt.
So should Eastern Iron (ASX:EFE) shareholders be worried about its cash burn? In this article, we define cash burn as its annual (negative) free cash flow, which is the amount of money a company spends each year to fund its growth. The first step is to compare its cash burn with its cash reserves, to give us its ‘cash runway’.
How Long Is Eastern Iron’s Cash Runway?
A company’s cash runway is calculated by dividing its cash hoard by its cash burn. As at June 2019, Eastern Iron had cash of AU$479k and no debt. In the last year, its cash burn was AU$548k. That means it had a cash runway of around 10 months as of June 2019. That’s quite a short cash runway, indicating the company must either reduce its annual cash burn or replenish its cash. The image below shows how its cash balance has been changing over the last few years.
How Is Eastern Iron’s Cash Burn Changing Over Time?
Whilst it’s great to see that Eastern Iron has already begun generating revenue from operations, last year it only produced AU$12k, so we don’t think it is generating significant revenue, at this point. As a result, we think it’s a bit early to focus on the revenue growth, so we’ll limit ourselves to looking at how the cash burn is changing over time. Given the length of the cash runway, we’d interpret the 22% reduction in cash burn, in twelve months, as prudent if not necessary for capital preservation. Admittedly, we’re a bit cautious of Eastern Iron due to its lack of significant operating revenues. We prefer most of the stocks on this list of stocks that analysts expect to grow.
How Hard Would It Be For Eastern Iron To Raise More Cash For Growth?
Even though it has reduced its cash burn recently, shareholders should still consider how easy it would be for Eastern Iron to raise more cash in the future. Generally speaking, a listed business can raise new cash through issuing shares or taking on debt. One of the main advantages held by publicly listed companies is that they can sell shares to investors to raise cash to fund growth. By comparing a company’s annual cash burn to its total market capitalisation, we can estimate roughly how many shares it would have to issue in order to run the company for another year (at the same burn rate).
Since it has a market capitalisation of AU$1.6m, Eastern Iron’s AU$548k in cash burn equates to about 33% of its market value. That’s not insignificant, and if the company had to sell enough shares to fund another year’s growth at the current share price, you’d likely witness fairly costly dilution.
So, Should We Worry About Eastern Iron’s Cash Burn?
Even though its cash burn relative to its market cap makes us a little nervous, we are compelled to mention that we thought Eastern Iron’s cash burn reduction was relatively promising. Summing up, we think the Eastern Iron’s cash burn is a risk, based on the factors we mentioned in this article. While we always like to monitor cash burn for early stage companies, qualitative factors such as the CEO pay can also shed light on the situation. Click here to see free what the Eastern Iron CEO is paid..
Of course Eastern Iron may not be the best stock to buy. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.
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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.