We're Not Counting On Tekcapital (LON:TEK) To Sustain Its Statutory Profitability

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. That said, the current statutory profit is not always a good guide to a company's underlying profitability. Today we'll focus on whether this year's statutory profits are a good guide to understanding Tekcapital (LON:TEK).

It's good to see that over the last twelve months Tekcapital made a profit of US$3.00m on revenue of US$5.18m. In the chart below, you can see that its profit and revenue have both grown over the last three years, albeit not in the last year.

View our latest analysis for Tekcapital

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. So today we'll look at what Tekcapital's cashflow tells us about its earnings, as well as examining how issuing shares is impacting shareholder value. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Tekcapital.

Zooming In On Tekcapital'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. 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.

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. 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 May 2020, Tekcapital had an accrual ratio of 0.22. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Even though it reported a profit of US$3.00m, a look at free cash flow indicates it actually burnt through US$2.0m in the last year. We also note that Tekcapital's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of US$2.0m. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. In fact, Tekcapital increased the number of shares on issue by 46% 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. Check out Tekcapital's historical EPS growth by clicking on this link.

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

Tekcapital has improved its profit over the last three years, with an annualized gain of 415% in that time. In comparison, earnings per share only gained 194% over the same period. Net profit actually dropped by 66% in the last year. Unfortunately for shareholders, though, the earnings per share result was even worse, declining 75%. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

If Tekcapital's 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 the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

Our Take On Tekcapital's Profit Performance

In conclusion, Tekcapital 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 Tekcapital'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. Our analysis shows 4 warning signs for Tekcapital (1 makes us a bit uncomfortable!) and we strongly recommend you look at these before investing.

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 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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