Why Diatreme Resources' (ASX:DRX) Healthy Earnings Aren’t As Good As They Seem

Diatreme Resources Limited (ASX:DRX) posted some decent earnings, but shareholders didn't react strongly. Our analysis suggests they may be concerned about some underlying details.

See our latest analysis for Diatreme Resources

Examining Cashflow Against 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. 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. 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 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".

Over the twelve months to December 2023, Diatreme Resources recorded an accrual ratio of 0.28. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Over the last year it actually had negative free cash flow of AU$2.8m, in contrast to the aforementioned profit of AU$10.4m. 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$2.8m. 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.

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

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by AU$14m, in the last year, probably goes some way to explain why its accrual ratio was so weak. 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. And, after all, that's exactly what the accounting terminology implies. Diatreme Resources had a rather significant contribution from unusual items relative to its profit to December 2023. 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 had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at Diatreme Resources' statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into Diatreme Resources, you'd also look into what risks it is currently facing. Every company has risks, and we've spotted 4 warning signs for Diatreme Resources (of which 2 shouldn't be ignored!) you should know about.

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. 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.

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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.