We Believe Advantage Energy's (TSE:AAV) Earnings Are A Poor Guide For Its Profitability

Advantage Energy Ltd.'s (TSE:AAV) stock rose after it released a robust earnings report. Despite the strong profit numbers, we believe that there are some deeper issues which investors should look into.

Check out our latest analysis for Advantage Energy

Examining Cashflow Against Advantage Energy'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

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. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to December 2021, Advantage Energy recorded an accrual ratio of 0.21. Unfortunately, that means its free cash flow fell significantly short of its reported profits. In fact, it had free cash flow of CA$85m in the last year, which was a lot less than its statutory profit of CA$411.5m. Given that Advantage Energy had negative free cash flow in the prior corresponding period, the trailing twelve month resul of CA$85m would seem to be a step in the right direction. 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. The good news for shareholders is that Advantage Energy's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

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.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CA$341m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. 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. Which is hardly surprising, given the name. We can see that Advantage Energy's positive unusual items were quite significant relative to its profit in the year to December 2021. 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 Advantage Energy's Profit Performance

Summing up, Advantage Energy received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For the reasons mentioned above, we think that a perfunctory glance at Advantage Energy's statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into Advantage Energy, you'd also look into what risks it is currently facing. In terms of investment risks, we've identified 1 warning sign with Advantage Energy, and understanding this should be part of your investment process.

Our examination of Advantage Energy 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 is always more to discover if you are capable of focussing your mind on minutiae. 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.