Stock Analysis

Why Atlas Pearls' (ASX:ATP) Earnings Are Weaker Than They Seem

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ASX:ATP
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Despite posting strong earnings, Atlas Pearls Ltd's (ASX:ATP) stock didn't move much over the last week. We looked deeper into the numbers and found that shareholders might be concerned with some underlying weaknesses.

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earnings-and-revenue-history
ASX:ATP Earnings and Revenue History September 7th 2021

A Closer Look At Atlas Pearls' 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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. This ratio tells us how much of a company's profit is not backed by free cashflow.

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.

Over the twelve months to June 2021, Atlas Pearls recorded an accrual ratio of 0.23. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. To wit, it produced free cash flow of AU$2.5m during the period, falling well short of its reported profit of AU$6.72m. Given that Atlas Pearls had negative free cash flow in the prior corresponding period, the trailing twelve month resul of AU$2.5m 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. One positive for Atlas Pearls shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. As a result, some shareholders may be looking for stronger cash conversion in the current year.

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

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Atlas Pearls' profit was boosted by unusual items worth AU$4.0m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. Which is hardly surprising, given the name. We can see that Atlas Pearls' positive unusual items were quite significant relative to its profit in the year to June 2021. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Atlas Pearls' Profit Performance

Summing up, Atlas Pearls received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Atlas Pearls' profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into Atlas Pearls, you'd also look into what risks it is currently facing. Be aware that Atlas Pearls is showing 3 warning signs in our investment analysis and 2 of those shouldn't be ignored...

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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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