Encounter Resources (ASX:ENR) Is Posting Solid Earnings, But It Is Not All Good News

Shareholders didn't seem to be thrilled with Encounter Resources Limited's (ASX:ENR) recent earnings report, despite healthy profit numbers. Our analysis suggests they may be concerned about some underlying details.

View our latest analysis for Encounter Resources

Examining Cashflow Against Encounter Resources' 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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, Encounter Resources recorded an accrual ratio of 0.83. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of AU$8.22m, a look at free cash flow indicates it actually burnt through AU$5.1m in the last year. We also note that Encounter Resources' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of AU$5.1m. However, that's not all there is to consider. 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 Encounter Resources.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by AU$9.5m, 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. 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 that's as you'd expect, given these boosts are described as 'unusual'. We can see that Encounter Resources' positive unusual items were quite significant relative to its profit in the year to December 2021. 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 Encounter Resources' Profit Performance

Summing up, Encounter Resources received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. On reflection, the above-mentioned factors give us the strong impression that Encounter Resources'underlying earnings power is not as good as it might seem, based on the statutory profit numbers. If you'd like to know more about Encounter Resources as a business, it's important to be aware of any risks it's facing. When we did our research, we found 3 warning signs for Encounter Resources (2 are potentially serious!) that we believe deserve your full attention.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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. 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.