Star Royalties' (CVE:STRR) Earnings Aren't As Good As They Appear

We didn't see Star Royalties Ltd.'s (CVE:STRR) 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.

Our analysis indicates that STRR is potentially undervalued!

A Closer Look At Star Royalties' 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. 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 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".

Over the twelve months to September 2022, Star Royalties recorded an accrual ratio of 0.50. 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$16.4m, a look at free cash flow indicates it actually burnt through US$973k 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 US$973k, this year, indicates high risk. 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 Star Royalties.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Star Royalties' profit was boosted by unusual items worth US$19m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. 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 Star Royalties' 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 Star Royalties' Profit Performance

Star Royalties had a weak accrual ratio, but its profit did receive a boost from unusual items. On reflection, the above-mentioned factors give us the strong impression that Star Royalties'underlying earnings power is not as good as it might seem, based on the statutory profit numbers. So while earnings quality is important, it's equally important to consider the risks facing Star Royalties at this point in time. Our analysis shows 3 warning signs for Star Royalties (2 are a bit unpleasant!) and we strongly recommend you look at these bad boys before investing.

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 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.