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We Think Encounter Resources (ASX:ENR) Needs To Drive Business Growth Carefully

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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 software-as-a-service business Salesforce.com lost money for years while it grew recurring revenue, if you held shares since 2005, you'd have done very well indeed. But while the successes are well known, investors should not ignore the very many unprofitable companies that simply burn through all their cash and collapse.

Given this risk, we thought we'd take a look at whether Encounter Resources (ASX:ENR) shareholders should be worried about its cash burn. In this report, we will consider the company's annual negative free cash flow, henceforth referring to it as the 'cash burn'. The first step is to compare its cash burn with its cash reserves, to give us its 'cash runway'.

View our latest analysis for Encounter Resources

When Might Encounter Resources Run Out Of Money?

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. When Encounter Resources last reported its balance sheet in June 2020, it had zero debt and cash worth AU$1.9m. In the last year, its cash burn was AU$3.0m. That means it had a cash runway of around 7 months as of 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. 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.

debt-equity-history-analysis
debt-equity-history-analysis

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. Admittedly, we're a bit cautious of Encounter Resources due to its lack of significant operating revenues. We prefer most of the stocks on this list of stocks that analysts expect to grow.

Can Encounter Resources Raise More Cash Easily?

Given its cash burn trajectory, Encounter Resources shareholders should already be thinking about how easy it might be for it to raise further 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 and 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).

Encounter Resources' cash burn of AU$3.0m is about 5.6% of its AU$54m market capitalisation. Given that is a rather small percentage, it would probably be really easy for the company to fund another year's growth by issuing some new shares to investors, or even by taking out a loan.

So, Should We Worry About Encounter Resources' Cash Burn?

On this analysis of Encounter Resources' cash burn, we think its cash burn relative to its market cap was reassuring, while its cash runway has us a bit worried. Summing up, we think the Encounter Resources' cash burn is a risk, based on the factors we mentioned in this article. Taking a deeper dive, we've spotted 6 warning signs for Encounter Resources you should be aware of, and 2 of them are concerning.

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.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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