By: Chris Tell
Burn Rate: Investopedia – “The rate at which a new company uses up its venture capital to finance overhead before generating positive cash flow from operations. In other words, it’s a measure of negative cash flow.”
DD101 always entails one particular question: What is the company’s cash flow? Is it positive or negative? A company is either bleeding or it is making money.
When dealing with a start-up or early stage PE deal, it’s typical to be looking at the former and evaluating the company’s “burn rate”.
Bear with me as we take an admittedly simplistic example and look at the hypothetical company I’ll call “Widget Ltd”:
- Cash in treasury: $350k
- Total debt: $0
- Monthly revenues: $10k
- Monthly expenditure: $50k
- Monthly burn rate: $40k
Now, if Widget Ltd are projecting positive cash flows within 18 months then we know that the existing $350k in the kitty will be vaporized in under 9 months. They will need to raise additional capital to reach the 18 month projected time frame in their bid to reach salvation.
Further capital raising will likely result in subsequent dilution to existing shareholders, and if the company fails for whatever reason to raise the additional capital to reach a positive cash flow status, then Widget Ltd risks simply blowing away in the wind…taking any and all investor capital with it.
Given this simple-to-understand exercise we can realistically determine, from a pure cash flow perspective, what our risk in either lending money to the company or buying equity in the company is.
I’ve worked in the investment world all my adult life and have always found that bringing metrics down to a basic level provides clarity of thought. With that in mind I’d like to take a look at an existing entity for a minute. This particular one boasts the following metrics.
- Net cash in treasury: ¥0 (Note: I said cash, not IOUs)
- Total debt stack: ¥1 Quadrillion. (1,000 Trillion)
- Revenues: ¥43 Trillion
- Ratio: Debt stack is 24 times Revenue
- Debt servicing costs or expenditure: ¥11 Trillion (at roughly 17-20 basis points)
- Burn rate: – ¥ 60.2 Trillion (based on their 10.3% of GDP budget deficit)
The above company is Japan Inc.
Now I can already hear all the MMT (Modern Monetary Theory) crowd balking. “Oh but you can’t compare a sovereign with a private company. They are completely different.” Are they really?
Let’s examine the standard stock arguments in point form.
- Japan can print its own currency
So what? so can Widget Ltd. It is called issuing more shares.
“Chris Widget Ltd can’t just keep issuing shares. Don’t be silly, eventually nobody will buy them.” Ah, very true but the real question to ask yourself is why?
The answer of course is that issuing more shares than the company is correspondingly producing in real growth, dilutes the company as each additional share issued is worth less than the previous ones.
So when Widget Ltd prints up more shares than it is creating in shareholder value then ceteris paribus, its shares should plummet and any continued share issuance will correspondingly be priced into the share price. Share count rises and per share value drops. I rest my case.
- Widget Ltd can’t be compared to a sovereign. Widget doesn’t have taxation authority whereas Japan does.
True, Widget Ltd has no taxation authority. However, if Widget Ltd obtains its cash flows from selling widgets, where then does Japan or any other sovereign obtain their cash flows? Taxation. A sovereign can increase taxes but not without a corresponding offset in GDP and/or a rising population. Widget Ltd can increase the sales price of its widgets but typically not without a corresponding decline in sales volume.
Sadly, neither a rising GDP nor a growing population are factors pertaining to Japan. The exact opposite is in fact true. Much as Widget Ltd experiences declining sales volumes on raising its prices, so too increased taxation has been proved to have a negative effect on GDP growth.
- Japan owes itself, hence no problem.
I love this one. Right, so when Joey down at the Tavern borrows $10,000 bucks from you he doesn’t really need to pay you back because after all you’re both from the same country, heck you’re both from the same neighbourhood, and maybe even from the same poker club.
The argument is pure nonsense. A bond is a contract between the lender and the borrower. It matters not if the lender is a Japanese citizen, a Kenyan or a Norwegian. That lender only lends the money in expectation of a return of principal and interest, while considering the implications of both inflation and deflation affecting the underlying currency.
- Japan issues its own bonds in Yen and can print Yen. The monetization process is completely different to a company issuing stock or bonds.
Well let’s see. Widget Ltd can issue bonds just like the BOJ. Widget LTD has to pay back those bonds in a currency not of their own control. This is all true. What is not considered is that Japan can only issue bonds denominated in Yen as long as the market retains faith in the value of the Yen. The two are intimately intertwined. Once again, not a whole lot different to Widget Ltd.
- But but, Japan is the largest creditor nation in the world
There you go again confusing a government with its citizens. Jeezuz, if I was to accuse most decent human beings of being equivalent to their government I’d be well deserved to lose the use of my kneecaps. Civilized, decent people should never be confused with institutions which serve as breeding ground for psychologically depraved, megalomaniacal, murderous thugs.
Economic principles exert themselves like gravity. Gravity affects any physical object on earth, and economic fundamentals, like gravity, eventually always exert themselves on participants.
We live in a world where social scientists, central bankers being only the most visible, have managed to make the abnormal now appear to be normal. With breathtaking audacity, greed and thievery these criminals continue to create layer upon layer of economic sewerage. It will come spewing forth onto the average and unknowing Joe Sixpack with the next spill likely coming in the form of the bond market entering bear market territory.
Joe Sixpack will be well primed to get hosed once again now that he has been lulled into the concept of forever low interest rates.
Man being a creature who consistently attempts to understand his world has labelled this the “new normal”. Complacency with this new normal grows each day, all the while the fundamentals erode beneath the surface.
The bed fellows of complacency can be found in VAR models being used by trading outfits. These models increasingly show reduced risks. How come?
The investment world is one of the most competitive environments there is, and this competition pushes risk in the best of circumstances. Backed by bail-outs, bail-ins and quantitative easing, trading models are reset to adjust to these risks…or lack thereof, depending on which side of the fence you’re sitting on.
This is how we find ourselves in a situation where Sovereign debt no longer trades according to historic default rates, but rather based on comparisons made with the rest of the world’s bankrupt nations. When the vast majority of developed countries are all bankrupt, it stands to reason that humans attempt to understand this anomaly.Understanding this and rationalizing it are two different things. Rationalizing the JGB 10 year bond yield is only possible when considering “the new normal”.
I believe a dangerous mistake lies in extrapolating the “new normal” into the future.
The tick is clocking…and Japan Inc. has the very real potential to send the world’s economies into a tailspin that will make 2008 look like a minor speed bump on the way to a concrete barrier.
If you haven’t read through our detailed complimentary report on how we are positioning for the coming Japanese unwind, please feel free to do so.
“This line of thinking which will ultimately lead the sheep to slaughter.” – Kyle Bass on being challenged on MMT