Even when a business is losing money, it's possible for shareholders to make money if they buy a good business at the right price. For example, although Amazon.com made losses for many years after listing, if you had bought and held the shares since 1999, you would have made a fortune. But the harsh reality is that very many loss making companies burn through all their cash and go bankrupt.
So, the natural question for Encounter Resources (ASX:ENR) shareholders is whether they should be concerned by its rate of cash burn. For the purposes of this article, cash burn is the annual rate at which an unprofitable company spends cash to fund its growth; its negative free cash flow. The first step is to compare its cash burn with its cash reserves, to give us its 'cash runway'.
Does Encounter Resources Have A Long Cash Runway?
A company's cash runway is the amount of time it would take to burn through its cash reserves at its current cash burn rate. When Encounter Resources last reported its balance sheet in June 2020, it had zero debt and cash worth AU$1.9m. Looking at the last year, the company burnt through AU$3.0m. That means it had a cash runway of around 7 months as of June 2020. That's quite a short cash runway, indicating the company must either reduce its annual cash burn or replenish its cash. However, if we extrapolate the company's recent cash burn trend, then it would have a longer cash run way. Depicted below, you can see how its cash holdings have changed over time.
How Is Encounter Resources' Cash Burn Changing Over Time?
While Encounter Resources did record statutory revenue of AU$42k over the last year, it didn't have any revenue from operations. To us, that makes it a pre-revenue company, so we'll look to its cash burn trajectory as an assessment of its cash burn situation. With the cash burn rate up 11% in the last year, it seems that the company is ratcheting up investment in the business over time. However, the company's true cash runway will therefore be shorter than suggested above, if spending continues to increase. Encounter Resources makes us a little nervous due to its lack of substantial operating revenue. We prefer most of the stocks on this list of stocks that analysts expect to grow.
How Hard Would It Be For Encounter Resources To Raise More Cash For Growth?
Since its cash burn is moving in the wrong direction, Encounter Resources shareholders may wish to think ahead to when the company may need to raise more cash. Issuing new shares, or taking on debt, are the most common ways for a listed company to raise more money for its business. One of the main advantages held by publicly listed companies is that they can sell shares to investors to raise cash and fund growth. We can compare a company's cash burn to its market capitalisation to get a sense for how many new shares a company would have to issue to fund one year's operations.
Encounter Resources' cash burn of AU$3.0m is about 5.7% of its AU$53m market capitalisation. That's a low proportion, so we figure the company would be able to raise more cash to fund growth, with a little dilution, or even to simply borrow some money.
How Risky Is Encounter Resources' Cash Burn Situation?
Even though its cash runway makes us a little nervous, we are compelled to mention that we thought Encounter Resources' cash burn relative to its market cap was relatively promising. Summing up, we think the Encounter Resources' cash burn is a risk, based on the factors we mentioned in this article. Separately, we looked at different risks affecting the company and spotted 6 warning signs for Encounter Resources (of which 2 can't be ignored!) you should know about.
Of course Encounter Resources 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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