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. Having said that, unprofitable companies are risky because they could potentially burn through all their cash and become distressed.
Given this risk, we thought we'd take a look at whether ArcWest Exploration (CVE:AWX) shareholders should 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. First, we'll determine its cash runway by comparing its cash burn with its cash reserves.
Does ArcWest Exploration Have A Long Cash Runway?
You can calculate a company's cash runway by dividing the amount of cash it has by the rate at which it is spending that cash. In September 2019, ArcWest Exploration had CA$979k in cash, and was debt-free. Looking at the last year, the company burnt through CA$1.5m. Therefore, from September 2019 it had roughly 8 months of cash runway. That's quite a short cash runway, indicating the company must either reduce its annual cash burn or replenish its cash. Depicted below, you can see how its cash holdings have changed over time.
How Is ArcWest Exploration's Cash Burn Changing Over Time?
Because ArcWest Exploration isn't currently generating revenue, we consider it an early-stage business. So while we can't look to sales to understand growth, we can look at how the cash burn is changing to understand how expenditure is trending over time. With the cash burn rate up 29% 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. Admittedly, we're a bit cautious of ArcWest Exploration due to its lack of significant operating revenues. So we'd generally prefer stocks from this list of stocks that have analysts forecasting growth.
Can ArcWest Exploration Raise More Cash Easily?
Since its cash burn is moving in the wrong direction, ArcWest Exploration shareholders may wish to think ahead to when the company may need to raise more cash. Companies can raise capital through either debt or equity. Many companies end up issuing new shares to fund future 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.
ArcWest Exploration has a market capitalisation of CA$5.3m and burnt through CA$1.5m last year, which is 28% of the company's 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.
Is ArcWest Exploration's Cash Burn A Worry?
ArcWest Exploration is not in a great position when it comes to its cash burn situation. While its cash burn relative to its market cap wasn't too bad, its cash runway does leave us rather nervous. Considering all the measures mentioned in this report, we reckon that its cash burn is fairly risky, and if we held shares we'd be watching like a hawk for any deterioration. For us, it's always important to consider risks around cash burn rates. But investors should look at a whole range of factors when researching a new stock. For example, it could be interesting to see how much the ArcWest Exploration CEO receives in total remuneration.
Of course ArcWest Exploration 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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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