We Wouldn't Rely On Sunstone Metals's (ASX:STM) Statutory Earnings As A Guide

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. That said, the current statutory profit is not always a good guide to a company's underlying profitability. Today we'll focus on whether this year's statutory profits are a good guide to understanding Sunstone Metals (ASX:STM).

While Sunstone Metals was able to generate revenue of AU$42.4k in the last twelve months, we think its profit result of AU$4.56m was more important. The chart below shows that while revenue has fallen over the last three years, the company has moved from unprofitable to profitable.

View our latest analysis for Sunstone Metals

Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. So this article aims to better understand Sunstone Metals' underlying earnings power by taking a look at how dilution, and unusual items are impacting it, and considering how well those paper profits are being converted into cash flow. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Sunstone Metals.

Examining Cashflow Against Sunstone Metals' 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. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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".

For the year to June 2020, Sunstone Metals had an accrual ratio of 0.45. 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$9.8m, in contrast to the aforementioned profit of AU$4.56m. We also note that Sunstone Metals' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of AU$9.8m. 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. One positive for Sunstone Metals shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. As a result, some shareholders may be looking for stronger cash conversion in the current year.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. Sunstone Metals expanded the number of shares on issue by 60% 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. Check out Sunstone Metals' historical EPS growth by clicking on this link.

How Is Dilution Impacting Sunstone Metals' Earnings Per Share? (EPS)

Three years ago, Sunstone Metals 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 fairly significant impact on shareholders.

If Sunstone Metals' EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Sunstone Metals' profit was boosted by unusual items worth AU$6.6m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And, after all, that's exactly what the accounting terminology implies. We can see that Sunstone Metals' positive unusual items were quite significant relative to its profit in the year to June 2020. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Sunstone Metals' Profit Performance

In conclusion, Sunstone Metals' weak accrual ratio suggested its statutory earnings have been inflated by the unusual items. The dilution means the results are weaker when viewed from a per-share perspective. For all the reasons mentioned above, we think that, at a glance, Sunstone Metals' statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. If you'd like to know more about Sunstone Metals as a business, it's important to be aware of any risks it's facing. When we did our research, we found 5 warning signs for Sunstone Metals (3 shouldn't be ignored!) that we believe deserve your full attention.

Our examination of Sunstone Metals 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 are plenty of other ways to inform your opinion of a company. 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. 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.
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