Why Core Lithium's (ASX:CXO) Healthy Earnings Aren’t As Good As They Seem

Following the release of a positive earnings report recently, Core Lithium Ltd's (ASX:CXO) stock performed well. Investors should be cautious however, as there some causes of concern deeper in the numbers.

See our latest analysis for Core Lithium

Zooming In On Core Lithium's 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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Core Lithium has an accrual ratio of 0.55 for the year to June 2023. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Over the last year it actually had negative free cash flow of AU$74m, in contrast to the aforementioned profit of AU$10.8m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of AU$74m, this year, indicates high risk. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. In fact, Core Lithium increased the number of shares on issue by 23% over the last twelve months by issuing new shares. Therefore, each share now receives a smaller portion of profit. 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. Check out Core Lithium's historical EPS growth by clicking on this link.

A Look At The Impact Of Core Lithium's Dilution On Its Earnings Per Share (EPS)

Three years ago, Core Lithium lost money. 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. So you can see that the dilution has had a fairly significant impact on shareholders.

In the long term, if Core Lithium'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 Core Lithium's Profit Performance

As it turns out, Core Lithium couldn't match its profit with cashflow and its dilution means that shareholders own less of the company than the did before (unless they bought more shares). Considering all this we'd argue Core Lithium's profits probably give an overly generous impression of its sustainable level of profitability. 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. Our analysis shows 2 warning signs for Core Lithium (1 is significant!) and we strongly recommend you look at these before investing.

Our examination of Core Lithium 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. 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.