We're Not So Sure You Should Rely on Transition Metals' (CVE:XTM) Statutory Earnings

As a general rule, we think profitable companies are less risky than companies that lose money. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. Today we'll focus on whether this year's statutory profits are a good guide to understanding Transition Metals (CVE:XTM).

We like the fact that Transition Metals made a profit of CA$2.34m on its revenue of CA$17.1k, in the last year. The chart below shows that while revenue has fallen over the last three years, the company has moved from unprofitable to profitable.

View our latest analysis for Transition Metals

Not all profits are equal, and we can learn more about the nature of a company's past profitability by diving deeper into the financial statements. So this article aims to better understand Transition Metals' underlying earnings power by taking a look at how dilution, and unusual items are impacting it, and considering how well those paper profits are being converted into cash flow. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Transition Metals.

Zooming In On Transition Metals' 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. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Transition Metals has an accrual ratio of 0.66 for the year to November 2020. 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. Even though it reported a profit of CA$2.34m, a look at free cash flow indicates it actually burnt through CA$150k in the last year. We also note that Transition Metals' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CA$150k. Having said that, there is more to consider. 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. One positive for Transition Metals shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. As a result, some shareholders may be looking for stronger cash conversion in the current year.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. In fact, Transition Metals increased the number of shares on issue by 20% over the last twelve months by issuing new shares. Therefore, each share now receives a smaller portion of profit. 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. You can see a chart of Transition Metals' EPS by clicking here.

How Is Dilution Impacting Transition Metals' Earnings Per Share? (EPS)

Three years ago, Transition Metals lost money. Zooming in to the last year, we still can't talk about growth rates coherently, since it made a loss last year. But mathematics aside, it is always good to see when a formerly unprofitable business come good (though we accept profit would have been higher if dilution had not been required). So you can see that the dilution has had a bit of an impact on shareholders. Therefore, the dilution is having a noteworthy influence on shareholder returns. And so, you can see quite clearly that dilution is influencing shareholder earnings.

If Transition Metals' EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. 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

Given the accrual ratio, it's not overly surprising that Transition Metals' profit was boosted by unusual items worth CA$2.0m 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 crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. Which is hardly surprising, given the name. Transition Metals had a rather significant contribution from unusual items relative to its profit to November 2020. 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 Transition Metals' Profit Performance

In conclusion, Transition Metals' 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. On reflection, the above-mentioned factors give us the strong impression that Transition Metals'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. Case in point: We've spotted 4 warning signs for Transition Metals you should be mindful of and 3 of them are a bit unpleasant.

Our examination of Transition Metals 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. 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. 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.
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