R.A.K. Ceramics P.J.S.C's (ADX:RAKCEC) Conservative Accounting Might Explain Soft Earnings

R.A.K. Ceramics P.J.S.C.'s (ADX:RAKCEC) recent soft profit numbers didn't appear to worry shareholders. We think that investors might be looking at some positive factors beyond the earnings numbers.

Check out our latest analysis for R.A.K. Ceramics P.J.S.C

Examining Cashflow Against R.A.K. Ceramics P.J.S.C's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. 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".

R.A.K. Ceramics P.J.S.C has an accrual ratio of -0.16 for the year to June 2021. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of د.إ548m in the last year, which was a lot more than its statutory profit of د.إ4.67m. R.A.K. Ceramics P.J.S.C's free cash flow improved over the last year, which is generally good to see. 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.

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.

How Do Unusual Items Influence Profit?

R.A.K. Ceramics P.J.S.C's profit was reduced by unusual items worth د.إ158m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. In the twelve months to June 2021, R.A.K. Ceramics P.J.S.C had a big unusual items expense. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.

Our Take On R.A.K. Ceramics P.J.S.C's Profit Performance

Considering both R.A.K. Ceramics P.J.S.C's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Based on these factors, we think R.A.K. Ceramics P.J.S.C's underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. Case in point: We've spotted 5 warning signs for R.A.K. Ceramics P.J.S.C you should be aware of.

After our examination into the nature of R.A.K. Ceramics P.J.S.C's profit, we've come away optimistic for the company. 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. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying to be useful.

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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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