We Think XTEK's (ASX:XTE) Profit Is Only A Baseline For What They Can Achieve

The subdued stock price reaction suggests that XTEK Limited's (ASX:XTE) strong earnings didn't offer any surprises. We think that investors have missed some encouraging factors underlying the profit figures.

See our latest analysis for XTEK

Zooming In On XTEK's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to June 2022, XTEK had an accrual ratio of -2.09. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of AU$24m in the last year, which was a lot more than its statutory profit of AU$5.74m. Notably, XTEK had negative free cash flow last year, so the AU$24m it produced this year was a welcome improvement. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings.

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

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. In fact, XTEK increased the number of shares on issue by 42% over the last twelve months by issuing new shares. Therefore, each share now receives a smaller portion of profit. 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. You can see a chart of XTEK's EPS by clicking here.

A Look At The Impact Of XTEK's Dilution On Its 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 don't have a meaningful growth rate because it made a loss a year ago, too. What we do know is that while it's great to see a profit over the last twelve months, that profit would have been better, on a per share basis, if the company hadn't needed to issue shares. Therefore, one can observe that the dilution is having a fairly profound effect on shareholder returns.

In the long term, if XTEK's earnings per share can increase, then the share price should too. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

Our Take On XTEK's Profit Performance

In conclusion, XTEK has a strong cashflow relative to earnings, which indicates good quality earnings, but the dilution means its earnings per share are dropping faster than its profit. Based on these factors, it's hard to tell if XTEK's profits are a reasonable reflection of its underlying profitability. If you want to do dive deeper into XTEK, you'd also look into what risks it is currently facing. While conducting our analysis, we found that XTEK has 2 warning signs and it would be unwise to ignore these bad boys.

Our examination of XTEK has focussed on certain factors that can make its earnings look better than they are. 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. 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.