In the surety underwriting business, we look to the future. Linking decisions are based on a variety of factors including “The Four C’s of Linking” (Read secret article #5). Collateral capacity levels are determined and used as a guide to manage the account. All of that makes sense.
However, prospective analysis makes assumptions, which may or may not be correct. If they are incorrect, the result could be devastating for the contractor and the warranty.
In this article we will delve into an aspect of valuation that is widely used by investors, but not so much by bond underwriters. It’s called Burn Rate.
Here is the definition of the internet:
Burn rate is the rate at which a business is losing money. It is normally expressed in monthly terms. For example, “The company’s consumption rate is currently $65,000 per month.” In this sense, the word “burn” is a term synonymous with negative cash flow.
It is also a measure of how quickly a company will use its equity capital. If shareholder capital dries up, the company will have to turn a profit, find additional financing, or go out of business.
Very interesting. The reason our insurers use the Burn Rate is because of the assumption that it doesn’t make…
Think about how a typical security line works. Bail bonding (the bail bond industry for that matter), assumes that your client will have enough work in the future to fill the bail bond capacity limits. But what if they don’t? Can we predict the company’s ability to survive with inadequate revenue and no profit? Wouldn’t this be an important measure of financial strength and staying power?
The Burn Rate allows us to find the “landing strip” of the company, which is the time it can survive without new funds coming in.
Here’s how to calculate a company’s financial runway, the length of time it can survive on existing capital. This is hard core analysis that removes any expectation of new revenue.
The formula requires two elements:
- Working Capital “As Allowed” Based on Underwriter Analysis
- Average monthly fixed expenses
Working capital (WC), as you’ll recall from Secret #4, is a measure of the company’s short-term financial strength. Calculate assets readily convertible to cash in the next tax period. Each the underwriter identifies this number during the review of its financial statements.
If future income is inadequate, what is the company’s ability to survive? Fixed Expenses help us determine this fact. These are expenses that don’t go away, even if there is no new income. Every month you pay rent, utilities, administrative staff, phone, maintenance, insurance, etc. These expenses are arriving regardless of how much or how little sales are achieved. In the absence of future income, it is the Working Capital that must pay these monthly bills. The Runway is the time that the company can operate in this mode. The Burn Rate reveals this survivability.
A real client:
12/31 Working capital as allowed on balance sheet = $1,099,000
1/13-12/31 Total Expenses from the Profit and Loss Statement (Not included Cost of goods sold, also known as Straight expenses) = $1,243,000
Burn Rate: Average Monthly Expenses = $1,243,000 / 12 = $104,000 per month
Hint: WC Divided by Average Monthly Fixed Expenses
$1,099,000 / $104,000 = 10.6 months
Based on the current expected cash flow, the company can cover its fixed (unavoidable) operating expenses for 10.6 months. even if you have no income/benefits from new income. The catwalk is 10.6 months old. This measure of survival can be compared from period to period, by year, or from company to company.
Our national underwriting department brings this high level of experience and will to all of your offer and performance sureties.