Cathedral Energy Services' (TSE:CET) Earnings Aren't As Good As They Appear

After announcing healthy earnings, Cathedral Energy Services Ltd.'s (TSE:CET) stock rose over the last week. However, we think that shareholders should be aware of some other factors beyond the profit numbers.

View our latest analysis for Cathedral Energy Services

Examining Cashflow Against Cathedral Energy Services' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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".

Cathedral Energy Services has an accrual ratio of 0.93 for the year to September 2022. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of CA$6.98m, a look at free cash flow indicates it actually burnt through CA$117m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CA$117m, this year, indicates high risk. Having said that, there is more to consider. 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. The good news for shareholders is that Cathedral Energy Services' 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. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

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, Cathedral Energy Services issued 178% more new shares over the last year. Therefore, each share now receives a smaller portion of profit. 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. You can see a chart of Cathedral Energy Services' EPS by clicking here.

A Look At The Impact Of Cathedral Energy Services' Dilution On Its Earnings Per Share (EPS)

Cathedral Energy Services was losing money three years ago. 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. But mathematics aside, it is always good to see when a formerly unprofitable business come good (though we accept profit would have been higher if dilution had not been required). And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

If Cathedral Energy Services' EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CA$5.9m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. 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. We can see that Cathedral Energy Services' positive unusual items were quite significant relative to its profit in the year to September 2022. 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 Cathedral Energy Services' Profit Performance

Cathedral Energy Services didn't back up its earnings with free cashflow, but this isn't too surprising given profits were inflated by unusual items. The dilution means the results are weaker when viewed from a per-share perspective. On reflection, the above-mentioned factors give us the strong impression that Cathedral Energy Services'underlying earnings power is not as good as it might seem, based on the statutory profit numbers. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Every company has risks, and we've spotted 3 warning signs for Cathedral Energy Services you should know about.

Our examination of Cathedral Energy Services 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 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. 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. 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.