We Don’t Think Spruce Ridge Resources' (CVE:SHL) Earnings Should Make Shareholders Too Comfortable

Shareholders were pleased with the recent earnings report from Spruce Ridge Resources Ltd. (CVE:SHL). However, we think that investors should be cautious when interpreting the profit numbers.

See our latest analysis for Spruce Ridge Resources

A Closer Look At Spruce Ridge Resources' 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. 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. 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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to January 2022, Spruce Ridge Resources had an accrual ratio of 0.79. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. In the last twelve months it actually had negative free cash flow, with an outflow of CA$2.4m despite its profit of CA$7.22m, mentioned above. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CA$2.4m, this year, indicates high risk. However, that's not the end of the story. 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Spruce Ridge Resources.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. Spruce Ridge Resources expanded the number of shares on issue by 16% 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 Spruce Ridge Resources' EPS by clicking here.

A Look At The Impact Of Spruce Ridge Resources' Dilution on Its Earnings Per Share (EPS).

Three years ago, Spruce Ridge Resources lost money. Even looking at the last year, profit was still down 70%. Like a sack of potatoes thrown from a delivery truck, EPS fell harder, down 78% in the same period. And so, you can see quite clearly that dilution is influencing shareholder earnings.

If Spruce Ridge Resources' 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 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.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Spruce Ridge Resources' profit was boosted by unusual items worth CA$9.2m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. Which is hardly surprising, given the name. Spruce Ridge Resources had a rather significant contribution from unusual items relative to its profit to January 2022. 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 Spruce Ridge Resources' Profit Performance

Spruce Ridge Resources didn't back up its earnings with free cashflow, but this isn't too surprising given profits were inflated by unusual items. Meanwhile, the new shares issued mean that shareholders now own less of the company, unless they tipped in more cash themselves. On reflection, the above-mentioned factors give us the strong impression that Spruce Ridge Resources'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. To help with this, we've discovered 4 warning signs (2 are a bit concerning!) that you ought to be aware of before buying any shares in Spruce Ridge Resources.

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.