Kinovo's (LON:KINO) Promising Earnings May Rest On Soft Foundations

Kinovo plc (LON:KINO) announced strong profits, but the stock was stagnant. Our analysis suggests that this might be because shareholders have noticed some concerning underlying factors.

Check out our latest analysis for Kinovo

Zooming In On Kinovo's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. 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".

For the year to September 2021, Kinovo had an accrual ratio of -0.21. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of UK£4.4m, well over the UK£1.35m it reported in profit. Kinovo did see its free cash flow drop year on year, which is less than ideal, like a Simpson's episode without Groundskeeper Willie. However, that's not the end of the story. 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.

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

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. In fact, Kinovo increased the number of shares on issue by 5.8% over the last twelve months by issuing new shares. As a result, its net income is now split between a greater number of shares. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. You can see a chart of Kinovo's EPS by clicking here.

How Is Dilution Impacting Kinovo's Earnings Per Share? (EPS)

As it happens, we don't know how much the company made or lost three years ago, because we don't have the data. On the bright side, in the last twelve months it grew profit by 184%. On the other hand, earnings per share are only up 165% over the same period. And so, you can see quite clearly that dilution is influencing shareholder earnings.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So Kinovo shareholders will want to see that EPS figure continue to increase. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Kinovo's profit was boosted by unusual items worth UK£326k in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's as you'd expect, given these boosts are described as 'unusual'. If Kinovo doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Kinovo's Profit Performance

Summing up, Kinovo's accrual ratio suggests that its statutory earnings are well matched by cash flow while its unusual items boosted the profit in a way that might not be repeated. Further, the dilution means profits are now split more ways. Having considered these factors, we don't think Kinovo's statutory profits give an overly harsh view of the business. So while earnings quality is important, it's equally important to consider the risks facing Kinovo at this point in time. While conducting our analysis, we found that Kinovo has 4 warning signs and it would be unwise to ignore these bad boys.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. But there are plenty of other ways to inform your opinion of a company. 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.