Why DataDot Technology's (ASX:DDT) Earnings Are Weaker Than They Seem

Despite posting strong earnings, DataDot Technology Limited's (ASX:DDT) stock didn't move much over the last week. We think that investors might be worried about the foundations the earnings are built on.

Check out our latest analysis for DataDot Technology

Zooming In On DataDot Technology's 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). 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

DataDot Technology has an accrual ratio of 1.87 for the year to December 2021. Ergo, its free cash flow is significantly weaker than its profit. As a general rule, that bodes poorly for future profitability. In fact, it had free cash flow of AU$1.1m in the last year, which was a lot less than its statutory profit of AU$7.27m. At this point we should mention that DataDot Technology did manage to increase its free cash flow in the last twelve months Importantly, we note an unusual tax situation, which we discuss below, has impacted the accruals ratio. This would certainly have contributed to the weak cash conversion.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of DataDot Technology.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that DataDot Technology profited from a tax benefit which contributed AU$5.8m to profit. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! Of course, prima facie it's great to receive a tax benefit. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth.

Our Take On DataDot Technology's Profit Performance

DataDot Technology's accrual ratio indicates weak cashflow relative to earnings, which perhaps arises in part from the tax benefit it received this year. If the tax benefit is not repeated, then profit would drop next year, all else being equal. For all the reasons mentioned above, we think that, at a glance, DataDot Technology's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. If you want to do dive deeper into DataDot Technology, you'd also look into what risks it is currently facing. To help with this, we've discovered 3 warning signs (2 shouldn't be ignored!) that you ought to be aware of before buying any shares in DataDot Technology.

Our examination of DataDot Technology 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 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.