Why Divergent Energy Services' (CVE:DVG) Earnings Are Weaker Than They Seem

Divergent Energy Services Corp.'s (CVE:DVG) stock rose after it released a robust earnings report. However, we think that shareholders should be aware of some other factors beyond the profit numbers.

See our latest analysis for Divergent Energy Services

A Closer Look At Divergent Energy Services' 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. The ratio shows us how much a company's profit exceeds its FCF.

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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Divergent Energy Services has an accrual ratio of 1.80 for the year to December 2021. Ergo, its free cash flow is significantly weaker than its profit. As a general rule, that bodes poorly for future profitability. In fact, it had free cash flow of US$1.4m in the last year, which was a lot less than its statutory profit of US$2.46m. Given that Divergent Energy Services had negative free cash flow in the prior corresponding period, the trailing twelve month resul of US$1.4m would seem to be a step in the right direction. 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Divergent Energy Services.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Divergent Energy Services' profit was boosted by unusual items worth US$669k in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. 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 that's as you'd expect, given these boosts are described as 'unusual'. Divergent Energy Services had a rather significant contribution from unusual items relative to its profit 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 Divergent Energy Services' Profit Performance

Summing up, Divergent Energy Services received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. On reflection, the above-mentioned factors give us the strong impression that Divergent Energy Services'underlying earnings power is not as good as it might seem, based on the statutory profit numbers. If you'd like to know more about Divergent Energy Services as a business, it's important to be aware of any risks it's facing. For example, we've found that Divergent Energy Services has 5 warning signs (4 are concerning!) that deserve your attention before going any further with your analysis.

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. 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.