West African Resources' (ASX:WAF) Promising Earnings May Rest On Soft Foundations

West African Resources Limited (ASX:WAF) announced strong profits, but the stock was stagnant. Our analysis suggests that this might be because shareholders have noticed some concerning underlying factors.

View our latest analysis for West African Resources

A Closer Look At West African 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. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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".

West African Resources has an accrual ratio of 0.22 for the year to December 2020. Unfortunately, that means its free cash flow fell significantly short of its reported profits. In fact, it had free cash flow of AU$31m in the last year, which was a lot less than its statutory profit of AU$89.4m. Notably, West African Resources had negative free cash flow last year, so the AU$31m it produced this year was a welcome improvement.

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.

Our Take On West African Resources' Profit Performance

West African Resources' accrual ratio for the last twelve months signifies cash conversion is less than ideal, which is a negative when it comes to our view of its earnings. Because of this, we think that it may be that West African Resources' statutory profits are better than its underlying earnings power. On the bright side, the company showed enough improvement to book a profit this year, after losing money last year. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. If you'd like to know more about West African Resources as a business, it's important to be aware of any risks it's facing. For example, West African Resources has 3 warning signs (and 1 which is significant) we think you should know about.

Today we've zoomed in on a single data point to better understand the nature of West African Resources' profit. 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. 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. 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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