We Wouldn't Rely On Dr. Hönle's (ETR:HNL) Statutory Earnings As A Guide

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. 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 Dr. Hönle (ETR:HNL).

While Dr. Hönle was able to generate revenue of €93.9m in the last twelve months, we think its profit result of €5.68m was more important. The chart below shows that both revenue and profit have declined over the last three years.

See our latest analysis for Dr. Hönle

Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. So today we'll look at what Dr. Hönle's cashflow tells us about its earnings, as well as examining how issuing shares is impacting shareholder value. That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

Zooming In On Dr. Hönle's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

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

Dr. Hönle has an accrual ratio of 0.25 for the year to September 2020. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. In the last twelve months it actually had negative free cash flow, with an outflow of €23m despite its profit of €5.68m, mentioned above. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of €23m, this year, indicates high risk. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. Dr. Hönle expanded the number of shares on issue by 10.0% over the last year. That means its earnings are split among a greater number of shares. 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. Check out Dr. Hönle's historical EPS growth by clicking on this link.

How Is Dilution Impacting Dr. Hönle's Earnings Per Share? (EPS)

Unfortunately, Dr. Hönle's profit is down 46% per year over three years. And even focusing only on the last twelve months, we see profit is down 54%. Like a sack of potatoes thrown from a delivery truck, EPS fell harder, down 54% in the same period. 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 Dr. Hönle'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 Dr. Hönle's Profit Performance

In conclusion, Dr. Hönle 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 Dr. Hönle's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Dr. Hönle as a business, it's important to be aware of any risks it's facing. Every company has risks, and we've spotted 4 warning signs for Dr. Hönle (of which 2 are a bit concerning!) you should know about.

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. Some people consider a high return on equity to be a good sign of a quality business. 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. 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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