Why Melbana Energy's (ASX:MAY) Earnings Are Weaker Than They Seem

Melbana Energy Limited (ASX:MAY) recently released a strong earnings report, and the market responded by raising the share price. Despite the strong profit numbers, we believe that there are some deeper issues which investors should look into.

See our latest analysis for Melbana Energy

Examining Cashflow Against Melbana Energy'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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to December 2021, Melbana Energy recorded an accrual ratio of 12.12. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of AU$8.36m, a look at free cash flow indicates it actually burnt through AU$21m in the last year. We also note that Melbana Energy's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of AU$21m. 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 Melbana Energy.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. As it happens, Melbana Energy issued 16% more new shares over the last year. 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 Melbana Energy's EPS by clicking here.

How Is Dilution Impacting Melbana Energy's Earnings Per Share? (EPS)

Three years ago, Melbana Energy lost money. Zooming in to the last year, we still can't talk about growth rates coherently, since it made a loss last year. But mathematics aside, it is always good to see when a formerly unprofitable business come good (though we accept profit would have been higher if dilution had not been required). So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, if Melbana Energy's earnings per share can increase, then the share price should too. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For that reason, you could say that EPS is more important that net income in the long run, assuming the goal is to assess whether a company's share price might grow.

Our Take On Melbana Energy's Profit Performance

In conclusion, Melbana Energy has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means that shareholders now own a smaller proportion of the company (assuming they maintained the same number of shares). Considering all this we'd argue Melbana Energy's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Melbana Energy as a business, it's important to be aware of any risks it's facing. Our analysis shows 4 warning signs for Melbana Energy (2 are concerning!) and we strongly recommend you look at them before investing.

Our examination of Melbana Energy 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 is always more to discover if you are capable of focussing your mind on minutiae. Some people consider a high return on equity to be a good sign of a quality business. 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.

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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.