Statutory Earnings May Not Be The Best Way To Understand Little Green Pharma's (ASX:LGP) True Position

After announcing healthy earnings, Little Green Pharma Ltd's (ASX:LGP) stock rose over the last week. While the headline numbers were strong, we found some underlying problems once we started looking at what drove earnings.

Check out our latest analysis for Little Green Pharma

Zooming In On Little Green Pharma's 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. 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. 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 June 2021, Little Green Pharma had an accrual ratio of 1.00. 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$24.6m, a look at free cash flow indicates it actually burnt through AU$6.2m in the last year. We also note that Little Green Pharma's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of AU$6.2m. However, that's not the end of the story. We must also consider the impact of unusual items on statutory profit (and thus the accrual ratio), as well as note the ramifications of the company issuing new shares.

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.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. As it happens, Little Green Pharma issued 73% more new shares over the last year. As a result, its net income is now split between 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 Little Green Pharma's historical EPS growth by clicking on this link.

A Look At The Impact Of Little Green Pharma's Dilution on Its Earnings Per Share (EPS).

Three years ago, Little Green Pharma lost money. And even focusing only on the last twelve months, we don't have a meaningful growth rate because it made a loss a year ago, too. What we do know is that while it's great to see a profit over the last twelve months, that profit would have been better, on a per share basis, if the company hadn't needed to issue shares. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

In the long term, if Little Green Pharma's earnings per share can increase, then the share price should too. 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$25m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. 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 that's as you'd expect, given these boosts are described as 'unusual'. Little Green Pharma had a rather significant contribution from unusual items relative to its profit to June 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 Little Green Pharma's Profit Performance

In conclusion, Little Green Pharma's weak accrual ratio suggested its statutory earnings have been inflated by the 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 Little Green Pharma'sunderlying earnings power is not as good as it might seem, based on the statutory profit numbers. If you want to do dive deeper into Little Green Pharma, you'd also look into what risks it is currently facing. In terms of investment risks, we've identified 3 warning signs with Little Green Pharma, and understanding them should be part of your investment process.

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. 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.
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