Cannara Biotech's (CVE:LOVE) Earnings Aren't As Good As They Appear

Even though Cannara Biotech Inc. (CVE:LOVE) posted strong earnings recently, the stock hasn't reacted in a large way. We think that investors might be worried about the foundations the earnings are built on.

See our latest analysis for Cannara Biotech

Examining Cashflow Against Cannara Biotech's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. 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".

Cannara Biotech has an accrual ratio of 0.54 for the year to November 2021. 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. In the last twelve months it actually had negative free cash flow, with an outflow of CA$32m despite its profit of CA$1.44m, mentioned above. We also note that Cannara Biotech's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CA$32m. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Cannara Biotech.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. As it happens, Cannara Biotech issued 19% more new shares over the last year. Therefore, each share now receives a smaller portion of profit. To talk about net income, without noticing earnings per share, is to be distracted by the big numbers while ignoring the smaller numbers that talk to per share value. Check out Cannara Biotech's historical EPS growth by clicking on this link.

A Look At The Impact Of Cannara Biotech's Dilution on Its Earnings Per Share (EPS).

Cannara Biotech was losing money three years ago. And even focusing only on the last twelve months, we don't have a meaningful growth rate because it made a loss a year ago, too. What we do know is that while it's great to see a profit over the last twelve months, that profit would have been better, on a per share basis, if the company hadn't needed to issue shares. And so, you can see quite clearly that dilution is influencing shareholder earnings.

If Cannara Biotech's 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.

Our Take On Cannara Biotech's Profit Performance

In conclusion, Cannara Biotech has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means that shareholders now own a smaller proportion of the company (assuming they maintained the same number of shares). Considering all this we'd argue Cannara Biotech's profits probably give an overly generous impression of its sustainable level of profitability. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. When we did our research, we found 3 warning signs for Cannara Biotech (1 can't be ignored!) that we believe deserve your full attention.

Our examination of Cannara Biotech 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. 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.