Just because a business does not make any money, does not mean that the stock will go down. Indeed, Sovereign Metals (ASX:SVM) stock is up 328% in the last year, providing strong gains for shareholders. Having said that, unprofitable companies are risky because they could potentially burn through all their cash and become distressed.
In light of its strong share price run, we think now is a good time to investigate how risky Sovereign Metals' cash burn is. 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. Let's start with an examination of the business' cash, relative to its cash burn.
See our latest analysis for Sovereign Metals
Does Sovereign Metals Have A Long Cash Runway?
A cash runway is defined as the length of time it would take a company to run out of money if it kept spending at its current rate of cash burn. As at June 2020, Sovereign Metals had cash of AU$2.4m and no debt. Importantly, its cash burn was AU$4.1m over the trailing twelve months. So it had a cash runway of approximately 7 months from June 2020. To be frank, this kind of short runway puts us on edge, as it indicates the company must reduce its cash burn significantly, or else raise cash imminently. Depicted below, you can see how its cash holdings have changed over time.
How Is Sovereign Metals' Cash Burn Changing Over Time?
Because Sovereign Metals isn't currently generating revenue, we consider it an early-stage business. Nonetheless, we can still examine its cash burn trajectory as part of our assessment of its cash burn situation. It's possible that the 17% reduction in cash burn over the last year is evidence of management tightening their belts as cash reserves deplete. Sovereign Metals makes us a little nervous due to its lack of substantial operating revenue. So we'd generally prefer stocks from this list of stocks that have analysts forecasting growth.
How Hard Would It Be For Sovereign Metals 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 Sovereign Metals to raise more cash in the future. Generally speaking, a listed business can raise new cash through issuing shares or taking on debt. Commonly, a business will sell new shares in itself to raise cash and drive growth. By looking at a company's cash burn relative to its market capitalisation, we gain insight on how much shareholders would be diluted if the company needed to raise enough cash to cover another year's cash burn.
Since it has a market capitalisation of AU$152m, Sovereign Metals' AU$4.1m in cash burn equates to about 2.7% of its market value. So it could almost certainly just borrow a little to fund another year's growth, or else easily raise the cash by issuing a few shares.
Is Sovereign Metals' Cash Burn A Worry?
Even though its cash runway makes us a little nervous, we are compelled to mention that we thought Sovereign Metals' cash burn relative to its market cap was relatively promising. Even though we don't think it has a problem with its cash burn, the analysis we've done in this article does suggest that shareholders should give some careful thought to the potential cost of raising more money in the future. On another note, we conducted an in-depth investigation of the company, and identified 4 warning signs for Sovereign Metals (1 is potentially serious!) that you should be aware of before investing here.
Of course Sovereign Metals 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.
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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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