Nano Caps: When to Expect a Placing

Investing in nano caps - which I will define as companies with a market capitalisation less than £30m - is fraught with difficulty. There are actually over 700 companies trading on the London Stock Exchange that fit into that bracket, yet most of these are subject to high volatility or illiquidity. One of the reasons why these companies are highly volatile is because they are often reliant on third party sources of funding, and these are usually in the form of a placing, which tends to erode shareholder value. That is a core reason why most picks in the site portfolio were of companies in sound financial positions; thus minimising the dilution risk.

It is important to be able to identify when a nano cap needs to raise fresh funds and frame an investment decision around that. After all, investing in one that probably needs to raise funds in the following months, could lead to the share price falling as the market prices in the dilutive effect of a placing.

However, simple financial analysis can be a quick and effective way to improve your chances of detecting companies that may need to raise money within 6-9 months. This analysis should assist in improved entry timing.

A Key Metric:  Adjusted Forecast Net Working Capital

The Net Working Capital ("NWC") of a company refers to metric that that can be found using numbers on a company's Balance Sheet. When a company releases a set of financial results, in the balance sheet you can find two terms; Current Assets and Current Liabilities. The formula for NWC is simply as below.

NWC = Current Assets - Current Liabilities

Rather than looking solely at that figure and whether it is useful, we need to perform a couple of modifications to achieve the Adjusted Forecast Net Working Capital (AFNWC) figure that is most useful when deciding whether a company is likely to require cash. First off we will deal with the Adjusted aspect, and then deal with the Forecast aspect.

This is particularly easy if the company does not generate revenues as the current assets and liabilities are likely to contain only a few terms. However, let's look at a slightly more complex example; what you should be trying to achieve is a conservative view of the company's short-term finances.

An Example: Byotrol (LSE:BYOT)

We start by finding the most recent set of financial results and extracting the Current Assets and Current Liabilities lines from the balance sheet, as below.

I have highlighted the relevant parts as per the previous text; we can ignore the non-current assets. The current assets total £1.636m and the current liabilities total £0.769m, giving a NWC position of £0.867m. However, recall that we are trying to form a conservative view of the company's financial position, and the best way to do this is include all current liabilities and only some current assets.

This is because a company may have to meet its liabilities before it can collect assets due to it. In addition, the inventories on book may not actually be bought during the period hence they are redundant assets and do not assist with the short-term financial position. Consequently, it is good practice to mentally discount the value of all Current Assets except for Cash and Equivalents. In Byotrol's example we can discount the value of Inventories and Trade Receivables by 50%. That means the Current Assets total drops to £1.107m and the NWC position drops to £0.338m. This is the Adjusted NWC position.

The second job to do is to adjust the figure for the Forecast aspect. The first step in this stage is to appreciate that the balance sheet is only valid off a specific date. In Byotrol's case the figures are valid as of 30th September 2014, as highlighted in the screenshot. We therefore need to factor in news released between September 30th and today, February 11th 2015.

Generally speaking, we only need to look at news announcements that will impact upon the cash position. For example, if a placing had taken place, you would want to add back the net cash proceeds from that into the balance sheet. If the company had purchased a new factory from the cash balance, you would want to subtract the cash cost from the cash line in current assets. In Byotrol's case, there have been no news statements since the results so we need not make those adjustments.

However, there is one very important thing left to do. That is to calculate a reasonable figure for the cash burn/generation that the company would have experienced between September 30th and today. To do this we need to look at the company's Cash Flow Statement and find a reasonable figure for the likely Free Cash Flow (see Cash Flow Statement Tutorial to learn about Free Cash Flow).

A simple but dirty way to do this is to look back at the free cash flow generated in the previous six months and then try to fit it to the time period in question. There have roughly been 5 and a half months since September 30th so we need to find the free cash flow for the previous six months, divide by 6 and then multiply by 5.5. Let's look at the cash flow statement and look for three things.
     1. The Operational Cash Generation before working capital movements
     2. Try to identify whether there has been any capitalised expenditure within Investing Cash Flows

Free cash flows for the previous six months were negative and totalled £326,707, excluding working capital changes. Dividing by 6 and multiplying by 5.5 and we can estimate that Byotrol would have burnt £299,481 since September 30th, as a base case.

Recall that the Adjusted NWC was £0.338m. We can now add the Free Cash Flow, which was negative, to this figure to obtain an AFNWC position of £0.011m. This would suggest that Byotrol is very close to running out of cash and may need to undertake a placing, hence you may decide to avoid the company until money has been raised.

As a rule of thumb, to decide whether the AFNWC position is sufficient, you should consider the period of time that it will cater for. If the AFNWC position is not enough to provide funds for six months (i.e. the free cash flow figure you just found), the company could be considered to be in a serious position where there is a relatively high chance of a placing. If there is insufficient cash for 12 months of free cash flow, there may be a medium-high chance of the company requiring a placing.

Remember that a company will usually seek to raise funds from a position of strength, so even if a company has enough cash for six months of cash burn, there may still be a placing. Companies tend to always want to have a cash buffer.

If the company typically generates sustained positive free cash flows or has enough cash for at least 18 months of cash burn, the chances of a placing can be considered to be materially lower.

Other Considerations

There are a number of other considerations that you may wish to consider when assessing the likelihood of a placing. Although the AFNWC calculation method could be considered as a key metric for checking, if any of these factors also hold, the risk may be heightened or diminished.

-  Does the company have any debt facilities in place or have the ability to raise debt?
This will probably be linked to the company's cash generating abilities. For example, a junior mining company with only exploration assets normally have to resort to placings rather than debt facilities given that they usually don't have any visible method of debt repayment that isn't highly speculative.

- What do the accountants, and what does the company narrative say?
This is probably one of the more stonewall considerations to take into account. A key part of a financial report are the "Going Concern" statements. Read through this to see whether the accountants/auditors believe the company has sufficient cash for at least the next twelve months (from the date of the results). Alternatively, the company may openly admit to needing cash, and it is wise to steer clear in these cases. Look at what Anglesey Mining (LSE:AYM) had to say in its last results.

- Are there serious alternatives to a placing?
Does the company have an asset that can realistically be sold or the stake reduced, as an alternative method of raising cash. For example, that may be through the sale of a mining deposit or the sale of a building. In most cases, this will not be a serious option given the long lead times involved with any sale or stake reduction.

- Has there been an increase in commissioned independent research or promotional activity?
A placing may follow a round of promotional activity by a company. Many companies struggle to undertake placings at an attractive price due to a lack of investor interest so they may seek to increase interest in the hope that the market will be more interested in a placing or in the hope that the share price will rise and make a placing easier.

- Does the company have a track record of placings under the management team?
If the management team at the company has diluted shareholders via placings numerous times in the past, chances are they will be willing to do it again, if required.