Shareholders Shouldn’t Be Too Comfortable With Dundee's (TSE:DC.A) Strong Earnings

Despite posting strong earnings, Dundee Corporation's (TSE:DC.A) stock didn't move much over the last week. We think that investors might be worried about the foundations the earnings are built on.

See our latest analysis for Dundee

Examining Cashflow Against Dundee'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. 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".

For the year to March 2021, Dundee had an accrual ratio of 0.23. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Even though it reported a profit of CA$77.5m, a look at free cash flow indicates it actually burnt through CA$15m in the last year. We also note that Dundee's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CA$15m. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part. One positive for Dundee 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.

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

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Dundee's profit was boosted by unusual items worth CA$103m in the last twelve months. 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 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. And, after all, that's exactly what the accounting terminology implies. We can see that Dundee's positive unusual items were quite significant relative to its profit in the year to March 2021. 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 Dundee's Profit Performance

Summing up, Dundee received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Dundee's profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Dundee at this point in time. For example, we've discovered 1 warning sign that you should run your eye over to get a better picture of Dundee.

Our examination of Dundee 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 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. 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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