Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it’s not always clear whether statutory profits are a good guide, going forward. This article will consider whether Diaceutics’ (LON:DXRX) statutory profits are a good guide to its underlying earnings.
While Diaceutics was able to generate revenue of UK£14.4m in the last twelve months, we think its profit result of UK£3.21m was more important.
Not all profits are equal, and we can learn more about the nature of a company’s past profitability by diving deeper into the financial statements. So today we’ll examine what Diaceutics’ cashflow and its expanding share count tell us about the nature of its profits. That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.
Examining Cashflow Against Diaceutics’ Earnings
One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. The ratio shows us how much a company’s profit exceeds its FCF.
Therefore, it’s actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. That is not intended to imply we should worry about a positive accrual ratio, but it’s worth noting where the accrual ratio is rather high. To quote a 2014 paper by Lewellen and Resutek, “firms with higher accruals tend to be less profitable in the future”.
Over the twelve months to June 2020, Diaceutics recorded an accrual ratio of 0.90. Statistically speaking, that’s a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of UK£3.8m, in contrast to the aforementioned profit of UK£3.21m. We also note that Diaceutics’ free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of UK£3.8m. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings.
To understand the value of a company’s earnings growth, it is imperative to consider any dilution of shareholders’ interests. As it happens, Diaceutics issued 21% more new shares over the last year. As a result, its net income is now split between a greater number of shares. To talk about net income, without noticing earnings per share, is to be distracted by the big numbers while ignoring the smaller numbers that talk to per share value. Check out Diaceutics’ historical EPS growth by clicking on this link.
How Is Dilution Impacting Diaceutics’ Earnings Per Share? (EPS)
As it happens, we don’t know how much the company made or lost three years ago, because we don’t have the data. And even focusing only on the last twelve months, we see profit is down . Sadly, earnings per share fell further, down a full 56% in that time. So you can see that the dilution has had a bit of an impact on shareholders. Therefore, the dilution is having a noteworthy influence on shareholder returns. And so, you can see quite clearly that dilution is influencing shareholder earnings.
If Diaceutics’ EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For that reason, you could say that EPS is more important that net income in the long run, assuming the goal is to assess whether a company’s share price might grow.
Our Take On Diaceutics’ Profit Performance
In conclusion, Diaceutics has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means that shareholders now own a smaller proportion of the company (assuming they maintained the same number of shares). Considering all this we’d argue Diaceutics’ profits probably give an overly generous impression of its sustainable level of profitability. With this in mind, we wouldn’t consider investing in a stock unless we had a thorough understanding of the risks. Case in point: We’ve spotted 4 warning signs for Diaceutics you should be mindful of and 2 of them can’t be ignored.
Our examination of Diaceutics has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. But there is always more to discover if you are capable of focussing your mind on minutiae. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to ‘follow the money’ and search out stocks that insiders are buying. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.
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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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