Highwood Asset Management's (CVE:HAM) Earnings Aren't As Good As They Appear

Highwood Asset Management Ltd.'s (CVE:HAM) 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.

View our latest analysis for Highwood Asset Management

A Closer Look At Highwood Asset Management'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). 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.

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. 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 December 2023, Highwood Asset Management had an accrual ratio of 0.49. 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 CA$46.1m, a look at free cash flow indicates it actually burnt through CA$2.4m in the last year. We also note that Highwood Asset Management's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CA$2.4m. Having said that, there is more to consider. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively.

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. Highwood Asset Management expanded the number of shares on issue by 152% over the last year. As a result, its net income is now split between a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. Check out Highwood Asset Management's historical EPS growth by clicking on this link.

A Look At The Impact Of Highwood Asset Management's Dilution On Its Earnings Per Share (EPS)

Three years ago, Highwood Asset Management lost money. The good news is that profit was up 1,954% in the last twelve months. But EPS was less impressive, up only 1,171% in that time. Therefore, one can observe that the dilution is having a fairly profound effect on shareholder returns.

In the long term, earnings per share growth should beget share price growth. So it will certainly be a positive for shareholders if Highwood Asset Management can grow EPS persistently. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For that reason, you could say that EPS is more important that net income in the long run, assuming the goal is to assess whether a company's share price might grow.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CA$38m, 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, after all, that's exactly what the accounting terminology implies. We can see that Highwood Asset Management's positive unusual items were quite significant relative to its profit in the year to December 2023. 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 Highwood Asset Management's Profit Performance

In conclusion, Highwood Asset Management's weak accrual ratio suggested its statutory earnings have been inflated by the unusual items. The dilution means the results are weaker when viewed from a per-share perspective. For all the reasons mentioned above, we think that, at a glance, Highwood Asset Management's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. If you want to do dive deeper into Highwood Asset Management, you'd also look into what risks it is currently facing. When we did our research, we found 5 warning signs for Highwood Asset Management (4 don't sit too well with us!) that we believe deserve your full attention.

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. 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.