In the surety underwriting business, we are forward looking. Bond decisions are based on a variety of factors including “The Four C’s of Bonding” (read our article #5). Underwriters make a detailed analysis, then set surety capacity levels to administer the account. That all makes sense.
However, the forward looking analysis makes assumptions – that may or may not be correct. If incorrect, the outcome could be devastating for the contractor and surety.
In this article we will delve into an aspect of evaluation used extensively by investors, but not so much by bond underwriters. It is called the Burn Rate. Mood Music: Click!
Here is the internet definition:
Burn Rate is the rate at which a company is losing money. It is typically expressed in monthly terms; “the company’s burn rate is currently $65,000 per month.” In this sense, the word “burn” is a synonymous term for negative cash flow.
It is also a measure for how fast a company will use up its shareholder capital. If the shareholder capital is exhausted, the company will either have to start making a profit, find additional funding, or close down.
Very interesting. The reason our underwriters use the Burn Rate is because of the assumption it does not make…
Think of the typical decision-making process. Working Capital (WC) and Net Worth are calculated then compared to the requested bonding limits. The underwriter wants to predict if the company’s financial strength is sufficient to support the amount of surety capacity. (A 10% case?) This evaluation is important, but it assumes the client will have enough future work to fill the bonding capacity limits. But what if they don’t? Can we predict the company’s ability to survive with inadequate revenues and in the absence of profits? Would this not be an important measure of financial strength and staying power?
The Burn Rate enables us to determine:
A company’s “Runway” is the time it can survive on existing capital without new funds coming in.
Here’s how to calculate a company’s financial Runway. This is a hard core analysis that eliminates all expectation of new revenues. The formula requires two elements:
- Working Capital “As Allowed” by the underwriter’s analysis
- Average monthly fixed expenses
Working Capital (WC), as you may recall in Secret #4, is a measure of the company’s short term financial strength. It calculates the assets readily convertible to cash in the next fiscal period. Every underwriter identifies this number during their financial statement review.
If future revenues are inadequate, what is the company’s survivability? The Fixed Expenses help us determine this fact. These are the expenses that don’t go away, even if there are no new revenues. Every month, you pay the rent, utilities, administrative staff, telephone, maintenance, insurance, etc. These expenses are coming regardless of how much or how little sales are achieved. In the absence of future revenues, it is Working Capital that must pay these monthly bills. The Runway is how long the company can operate in this mode. The Burn Rate reveals this survivability.
An actual client:
12/31 Working Capital As Allowed from the Balance Sheet = $1,099,000
1/31-12/31 Total Expenses from the Profit and Loss Statement (not including Cost of Goods Sold, aka Direct Expenses) = $1,243,000
Burn Rate: Average Monthly Expenses = $1,243,000 / 12 = $104,000 per month
Runway: WC Divided by Average Monthly Fixed Expenses
$1,099,000 / $104,000 = 10.6 months
Based on current expected cash flow, the company can cover it’s fixed (unavoidable) operating expenses for 10.6 months even if it has no income/ profits from new revenues. The Runway is 10.6 months. This measure of survivability can be compared from period to period, by year, or from one company to another.
Don’t forget, when the mood music stops, the party is not over. Our national underwriting department brings this high level of expertise and willingness to all your bid and performance bonds.
Call us when you need a corporate surety with excellent credentials and capacity on surety bonds up to $10,000,000. Excellence in underwriting, aggressive, creative, fast. Underwriting the way you wished it would be.
Steve Golia is a long established surety bond provider and expert. Call us with your next bid or performance bond.