We're Not Counting On Sharda Motor Industries (NSE:SHARDAMOTR) To Sustain Its Statutory Profitability

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. 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. Today we'll focus on whether this year's statutory profits are a good guide to understanding Sharda Motor Industries (NSE:SHARDAMOTR).

It's good to see that over the last twelve months Sharda Motor Industries made a profit of ₹523.9m on revenue of ₹8.63b. Below, you can see that both its revenue and its profit have fallen over the last three years.

See our latest analysis for Sharda Motor Industries

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 look at what Sharda Motor Industries' cashflow tells us about the quality of its earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Sharda Motor Industries.

Zooming In On Sharda Motor Industries' Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. 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 March 2020, Sharda Motor Industries recorded an accrual ratio of 0.65. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. In the last twelve months it actually had negative free cash flow, with an outflow of ₹964.9m despite its profit of ₹523.9m, mentioned above. It's worth noting that Sharda Motor Industries generated positive FCF of ₹297m a year ago, so at least they've done it in the past.

Our Take On Sharda Motor Industries' Profit Performance

As we have made quite clear, we're a bit worried that Sharda Motor Industries didn't back up the last year's profit with free cashflow. As a result, we think it may well be the case that Sharda Motor Industries' underlying earnings power is lower than its statutory profit. In further bad news, its earnings per share decreased in the last year. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. 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 3 warning signs for Sharda Motor Industries you should be mindful of and 1 of them is potentially serious.

Today we've zoomed in on a single data point to better understand the nature of Sharda Motor Industries' profit. But there are plenty of other ways to inform your opinion of a company. 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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