The biotech industry is rife with small companies that spend millions developing new drugs that may -- or may not – get the green light from the Food and Drug Administration. Many biotechs face costly setbacks, like clinical trial failures or regulatory delays, that can rapidly deplete their cash reserves. Even those that are ultimately successful typically don't have enough money to take a new drug all the way from the laboratory to the market.

So how can investors avoid getting burned by companies in this cash-hungry industry?

Follow the money
When analyzing a biotech stock, one of the first things investors need to calculate is how much money the company is spending. This number, called the "burn rate," is the total amount of cash that's spent on operations and capital expenditures. Let's run through an example and look at how much obesity-drug developer Orexigen Therapeutics (NASDAQ:OREX) has been spending.

Period

Q4 2012

Q3 2012

Q2 2012

Q1 2012

Operating Cash Flow

($27,359)

($19,231)

($12,878)

($8,874)

Capital Expenditure

$0

$0

$0

$0

Burn Rate

($27,359)

($19,231)

($12,878)

($8,874)

Avg. Burn Rate (LFQ)

($17,086)

     

Source: CapitalIQ; LFQ = last four quarters. All numbers in thousands.

On average, Orexigen has been burning $17 million a quarter -- but don't be alarmed. The massive costs associated with drug development make biotechs notorious for their high burn rates, and this number tells only half of the story.

How much cash is available?
Investors also have to gauge whether the company has enough money to support these expenses. Let's take a peek at Orexigen's balance sheet and see how much cash it has on hand:

Cash and Equivalents

$78,332

Short Term Investments

$59,071

Total cash on hand

$137,403

Source: CapitalIQ; data from most recent quarter. All numbers in thousands.

It appears that Orexigen had $137.4 million available at the end of last quarter. Assuming that its average burn rate stays constant, Orexigen can cover its expenses for a little less than two years.

Dilution?
Orexigen's strong cash position is partly due to capital that it raised through a recent follow-on public offering. It issued 11 million new shares last October and netted $56.5 million from the offering to help fuel its research and development efforts. And this wasn't the first time the company issued more shares; since the start of 2010, Orexigen's total outstanding share count has almost doubled from 47.2 million to 92.6 million. This means that investors who jumped into this stock three years ago have seen their total stake in the company drop by about 50%.

Today, however, the real question investors have to ask themselves is whether Orexigen can reach its next catalyst without running out of cash and issuing more shares.

Where does Orexigen stand?
Orexigen specializes in developing medications for the treatment of obesity, and while it has yet to get its products on the market, it currently has two drugs in late-stage clinical trials. Empatic, a combination of two generic drugs called bupropion and zonisamide, has finished its phase 2 clinical trials. Its leading drug, Contrave, is similar and combines bupropion with a different drug called naltrexone.

Orexigen completed its phase 3 clinical trials for Contrave back in 2010 but faced an FDA rejection in 2011 because of cardiac safety risks associated with the treatment. The company is determined to get the stamp of approval from the FDA and is currently completing a cardiovascular outcomes study to demonstrate Contrave's safety. Orexigen completed the patient enrollment for this trial late last year.

Orexigen's nearest potential catalyst is its Q1 report, which will be released after the market closes Wednesday. In addition to possible regulatory updates, this report will also give investors a chance to reassess the company's cash burn rate. Based on its strong cash position last quarter, however, dilution seems unlikely, and investors should instead focus on Contrave's upcoming clinical trial results. The interim results should be released sometime in 2013, and this will offer clues as to whether the company can successfully reapply for FDA approval toward the end of this year or 2014.

Max Macaluso, Ph.D., and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.