Direcional Engenharia (BVMF:DIRR3) Posted Healthy Earnings But There Are Some Other Factors To Be Aware Of

Direcional Engenharia S.A.'s (BVMF:DIRR3) robust earnings report didn't manage to move the market for its stock. Our analysis suggests that shareholders have noticed something concerning in the numbers.

View our latest analysis for Direcional Engenharia

Zooming In On Direcional Engenharia's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Direcional Engenharia has an accrual ratio of 0.28 for the year to December 2023. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Even though it reported a profit of R$331.6m, a look at free cash flow indicates it actually burnt through R$195m in the last year. We saw that FCF was R$164m a year ago though, so Direcional Engenharia has at least been able to generate positive FCF in the past. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

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.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Direcional Engenharia issued 16% more new shares over the last year. That means its earnings are split among a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. Check out Direcional Engenharia's historical EPS growth by clicking on this link.

A Look At The Impact Of Direcional Engenharia's Dilution On Its Earnings Per Share (EPS)

Direcional Engenharia has improved its profit over the last three years, with an annualized gain of 216% in that time. But EPS was only up 191% per year, in the exact same period. And at a glance the 74% gain in profit over the last year impresses. On the other hand, earnings per share are only up 62% in that time. So you can see that the dilution has had a bit of an impact on shareholders.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So it will certainly be a positive for shareholders if Direcional Engenharia can grow EPS persistently. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

Our Take On Direcional Engenharia's Profit Performance

In conclusion, Direcional Engenharia has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means its earnings per share growth is weaker than its profit growth. Considering all this we'd argue Direcional Engenharia's profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into Direcional Engenharia, you'd also look into what risks it is currently facing. For instance, we've identified 2 warning signs for Direcional Engenharia (1 shouldn't be ignored) you should be familiar with.

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. 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. 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.