Stock Analysis

Is There More To The Story Than Circa Enterprises' (CVE:CTO) Earnings Growth?

TSXV:CTO
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Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. This article will consider whether Circa Enterprises' (CVE:CTO) statutory profits are a good guide to its underlying earnings.

While Circa Enterprises was able to generate revenue of CA$28.8m in the last twelve months, we think its profit result of CA$1.91m was more important. Happily, it has grown both its profit and revenue over the last three years (though we note its revenue is down over the last year).

See our latest analysis for Circa Enterprises

earnings-and-revenue-history
TSXV:CTO Earnings and Revenue History February 7th 2021

Importantly, statutory profits are not always the best tool for understanding a company's true earnings power, so it's well worth examining profits in a little more detail. So today we'll look at what Circa Enterprises' cashflow and unusual items tell us about the quality of its earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Circa Enterprises.

Zooming In On Circa Enterprises' 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. 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.

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 September 2020, Circa Enterprises had an accrual ratio of -0.12. That indicates that its free cash flow was a fair bit more than its statutory profit. To wit, it produced free cash flow of CA$3.4m during the period, dwarfing its reported profit of CA$1.91m. Circa Enterprises' free cash flow improved over the last year, which is generally good to see. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Circa Enterprises' profit was boosted by unusual items worth CA$1.5m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. 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, after all, that's exactly what the accounting terminology implies. Circa Enterprises had a rather significant contribution from unusual items relative to its profit to September 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 Circa Enterprises' Profit Performance

Circa Enterprises' profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Based on these factors, we think it's very unlikely that Circa Enterprises' statutory profits make it seem much weaker than it is. So while earnings quality is important, it's equally important to consider the risks facing Circa Enterprises at this point in time. Be aware that Circa Enterprises is showing 4 warning signs in our investment analysis and 1 of those is significant...

Our examination of Circa Enterprises has focussed on certain factors that can make its earnings look better than they are. 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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