We Think Abu Dhabi Ship Building PJSC's (ADX:ADSB) Solid Earnings Are Understated

Abu Dhabi Ship Building PJSC's (ADX:ADSB) robust recent earnings didn't do much to move the stock. However the statutory profit number doesn't tell the whole story, and we have found some factors which might be of concern to shareholders.

Check out our latest analysis for Abu Dhabi Ship Building PJSC

A Closer Look At Abu Dhabi Ship Building PJSC's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. The ratio shows us how much a company's profit exceeds its FCF.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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 September 2021, Abu Dhabi Ship Building PJSC recorded an accrual ratio of -0.31. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of د.إ170m, well over the د.إ24.2m it reported in profit. Given that Abu Dhabi Ship Building PJSC had negative free cash flow in the prior corresponding period, the trailing twelve month resul of د.إ170m would seem to be a step in the right direction. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Abu Dhabi Ship Building PJSC.

The Impact Of Unusual Items On Profit

Surprisingly, given Abu Dhabi Ship Building PJSC's accrual ratio implied strong cash conversion, its paper profit was actually boosted by د.إ18m in unusual items. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. Which is hardly surprising, given the name. Abu Dhabi Ship Building PJSC had a rather significant contribution from unusual items relative to its profit to September 2021. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Abu Dhabi Ship Building PJSC's Profit Performance

Abu Dhabi Ship Building PJSC's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Given the contrasting considerations, we don't have a strong view as to whether Abu Dhabi Ship Building PJSC's profits are an apt reflection of its underlying potential for profit. So while earnings quality is important, it's equally important to consider the risks facing Abu Dhabi Ship Building PJSC at this point in time. Every company has risks, and we've spotted 2 warning signs for Abu Dhabi Ship Building PJSC you should know about.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. But there are plenty of other ways to inform your opinion of a company. Some people consider a high return on equity to be a good sign of a quality business. 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.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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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