We Believe Diatreme Resources' (ASX:DRX) Earnings Are A Poor Guide For Its Profitability

Despite posting strong earnings, Diatreme Resources Limited's (ASX:DRX) 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.

Check out our latest analysis for Diatreme Resources

Zooming In On Diatreme Resources' 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. The ratio shows us how much a company's profit exceeds its FCF.

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. 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 December 2022, Diatreme Resources had an accrual ratio of 0.44. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of AU$9.6m, in contrast to the aforementioned profit of AU$4.98m. We also note that Diatreme Resources' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of AU$9.6m. 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.

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

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. As it happens, Diatreme Resources issued 23% more new shares over the last year. That means its earnings are split among a greater number of shares. 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 Diatreme Resources' EPS by clicking here.

How Is Dilution Impacting Diatreme Resources' Earnings Per Share (EPS)?

Diatreme Resources was losing money three years ago. 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.

If Diatreme Resources' EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. 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.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by AU$8.3m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And, after all, that's exactly what the accounting terminology implies. We can see that Diatreme Resources' positive unusual items were quite significant relative to its profit in the year to December 2022. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Diatreme Resources' Profit Performance

Diatreme Resources didn't back up its earnings with free cashflow, but this isn't too surprising given profits were inflated by unusual items. Meanwhile, the new shares issued mean that shareholders now own less of the company, unless they tipped in more cash themselves. On reflection, the above-mentioned factors give us the strong impression that Diatreme Resources'underlying earnings power is not as good as it might seem, based on the statutory profit numbers. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Our analysis shows 4 warning signs for Diatreme Resources (2 are concerning!) and we strongly recommend you look at these before investing.

Our examination of Diatreme Resources 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.