Shareholders In Touchstone Exploration (TSE:TXP) Should Look Beyond Earnings For The Full Story

We didn't see Touchstone Exploration Inc.'s (TSE:TXP) stock surge when it reported robust earnings recently. We looked deeper into the numbers and found that shareholders might be concerned with some underlying weaknesses.

View our latest analysis for Touchstone Exploration

Examining Cashflow Against Touchstone Exploration'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). 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".

Touchstone Exploration has an accrual ratio of 0.52 for the year to December 2021. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of US$5.72m, a look at free cash flow indicates it actually burnt through US$26m in the last year. We also note that Touchstone Exploration's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of US$26m. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

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 US$13m, 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 analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's as you'd expect, given these boosts are described as 'unusual'. We can see that Touchstone Exploration'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 Touchstone Exploration's Profit Performance

Touchstone Exploration had a weak accrual ratio, but its profit did receive a boost from unusual items. For all the reasons mentioned above, we think that, at a glance, Touchstone Exploration's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. While conducting our analysis, we found that Touchstone Exploration has 1 warning sign and it would be unwise to ignore it.

Our examination of Touchstone Exploration 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. 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.