Here's Why We Don't Think Kip McGrath Education Centres's (ASX:KME) Statutory Earnings Reflect Its Underlying Earnings Potential

Broadly speaking, profitable businesses are less risky than unprofitable ones. That said, the current statutory profit is not always a good guide to a company's underlying profitability. This article will consider whether Kip McGrath Education Centres' (ASX:KME) statutory profits are a good guide to its underlying earnings.

We like the fact that Kip McGrath Education Centres made a profit of AU$1.57m on its revenue of AU$17.1m, in the last year. In the chart below, you can see that its profit and revenue have both grown over the last three years, although its profit has slipped in the last twelve months.

Check out our latest analysis for Kip McGrath Education Centres

Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. Therefore, today we'll take a look at Kip McGrath Education Centres' cashflow, share issues and unusual items with a view to better understanding the nature of its statutory earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Kip McGrath Education Centres.

Zooming In On Kip McGrath Education Centres' 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to June 2020, Kip McGrath Education Centres had an accrual ratio of 0.25. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Indeed, in the last twelve months it reported free cash flow of AU$25k, which is significantly less than its profit of AU$1.57m. Kip McGrath Education Centres shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months. However, that's not the end of the story. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively. One positive for Kip McGrath Education Centres 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.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. In fact, Kip McGrath Education Centres increased the number of shares on issue by 15% over the last twelve months by issuing new shares. That means its earnings are split among a greater number of shares. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. You can see a chart of Kip McGrath Education Centres' EPS by clicking here.

How Is Dilution Impacting Kip McGrath Education Centres' Earnings Per Share? (EPS)

Kip McGrath Education Centres has improved its profit over the last three years, with an annualized gain of 9.5% in that time. Net income was down 41% over the last twelve months. But the EPS result was even worth, with the company recording a decline of 41%. So you can see that the dilution has had a bit of an impact on shareholders. Therefore, the dilution is having a noteworthy influence on shareholder returns. And so, you can see quite clearly that dilution is influencing shareholder earnings.

If Kip McGrath Education Centres' EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Kip McGrath Education Centres' profit was boosted by unusual items worth AU$444k 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 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. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Kip McGrath Education Centres' Profit Performance

Kip McGrath Education Centres didn't back up its earnings with free cashflow, but this isn't too surprising given profits were inflated by unusual items. The dilution means the results are weaker when viewed from a per-share perspective. For the reasons mentioned above, we think that a perfunctory glance at Kip McGrath Education Centres' statutory profits might make it look better than it really is on an underlying level. 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. Be aware that Kip McGrath Education Centres is showing 6 warning signs in our investment analysis and 1 of those is concerning...

Our examination of Kip McGrath Education Centres 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. 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. 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.

If you’re looking to trade Kip McGrath Education Centres, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

This article by Simply Wall St is general in nature. 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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com.