Burn rate refers to the rate at which a company uses up its supply of cash over time. It's the rate of negative cash flow, usually quoted as a monthly rate, but in some crisis situations, it might be measured in weeks or even days.
Analysis of cash consumption tells investors whether a company is self sustaining, and signals the need for future financing. Be careful around companies with high cash burn rates. These investments can turn to ashes. (For background reading on the burn rate and other signs a stock is headed for trouble, see Are Your Stocks Doomed?)
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Getting Burned by the Burn Rate
If a company's cash burn continues over an extended period of time, then the company is operating on stockholder equity funds and borrowed capital. When a business like this seeks additional investment capital, investors need to pay close attention to the rate at which it's burning cash.
Burn rate is mainly an issue for newer, unprofitable companies in exciting growth industries. As it takes a while for many young firms to generate cash from operations, their survival depends on having an adequate supply of cash on hand to meet expenses. Many IT and biotech companies face years of living on their bank balances.
But burn rates are important also for mature companies that are struggling and burdened with excessive debt. Think of airline stocks. In 2001-2002, escalating competition combined with major crises placed the largest air carriers in a cash crunch that threatened industry collapse. United Airlines, for instance, suffered a daily cash burn of more than $7 million before seeking bankruptcy protection.
Cash burn is a worry. If companies burn cash too fast, they run the risk of going out of business. That said, if they burn cash too slowly, they risk falling behind in the competition to innovate, expand and gain market share. Good management manages cash well. (For more insight, see Cash: Can A Company Have Too Much?)
Calculating a Company's Burn Rate
The burn rate is determined by looking at the cash flow statement. Recall that the cash flows statement reports the change in the firm's cash position from one period to the next by accounting for the cash flows from operations, investment activities and financing activities.
|Burn Rate = Total Cash Position Change/Specified Time Period|
Compared to the amount of cash a company has on hand, the burn rate gives investors a sense of how much time is left before the company runs out of cash - assuming no change in the burn rate.
|Time Before Cash Runs Out = Cash Reserves/Burn
If you want to know if a company is really in trouble, compare its burn rate with the working capital measured over the same time period:
An Illustration of Burn Rate
To illustrate, consider the cash flows of a hypothetical company - Super Biosciences. Let's focus on a few key cash flow items relevant to Super's burn rate.
For starters, let's say that net cash from operating activities was negative $5.742 million for the first nine months of the year. This means that the core business operations burned cash at a rate of about $640,000 per month, largely thanks to continued operating losses.
In addition, suppose that Super made some new investments in capital assets. As a result, the net cash flow from investing was also negative, to the tune of about $1.9 million. That represents another big use of cash. In, the net cash burned by operations and investing amounted to over $7.3 million - a burn rate of more than $800,000 per month.
Some analysts argue that a more appropriate way to estimate cash burn is to ignore the cash from investing and financing and simply focus on cash from operations. But that doesn't seem too prudent, because most firms do have to make some capital expenditure in order to continue investing.
So, let's say that Super Biosciences has about $10.8 million in cash at the end of the period. Assuming Super Biosciences' current cash burn rate doesn't ease up, the company will run out of cash in about 13 months. Super's working capital burn rate is also roughly 13 months. That leaves the company some time to avoid the fate of running out of cash. This is what it will have to do:
- Decrease its burn rate through cost reductions, or by generating more cash from business operations.
- Sell off company assets.
- Raise external finance by issuing debt or equity.
Of course, the ability to raise more capital is not guaranteed for any firm, and it's especially tricky for small, risky technology companies. Executives must take advantage of favorable financing periods to boost the bank account for leaner years ahead. If a company plans to raise needed finance through a share issue, it needs to do it sooner rather than later. It can take six months or more to raise additional equity. (To learn about how a company issues shares, read IPO Basics: What Is An IPO?)
The Bottom Line
When investor enthusiasm is high, unprofitable companies can finance cash burn by issuing new shares, and shareholders are happy to cover cash burn - think of the internet boom in the late 1990s. But when the excitement wanes, companies can get stuck living on their bank balances, scrounging for unfavorable finance, being forced to merge or worse, go bust. For investors, it's important to follow a company's available cash, evaluating how long it will last and what will happen when it runs out.
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