We Believe Cadence Minerals' (LON:KDNC) Earnings Are A Poor Guide For Its Profitability

Cadence Minerals Plc (LON:KDNC) recently released a strong earnings report, and the market responded by raising the share price. Despite the strong profit numbers, we believe that there are some deeper issues which investors should look into.

See our latest analysis for Cadence Minerals

A Closer Look At Cadence Minerals' 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. The ratio shows us how much a company's profit exceeds its FCF.

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".

Cadence Minerals has an accrual ratio of 1.14 for the year to December 2020. 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. Even though it reported a profit of UK£7.82m, a look at free cash flow indicates it actually burnt through UK£1.4m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of UK£1.4m, this year, indicates high risk. Having said that, there is more to consider. 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 Cadence Minerals.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. Cadence Minerals expanded the number of shares on issue by 15% over the last year. That means its earnings are split among a greater number of shares. 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. You can see a chart of Cadence Minerals' EPS by clicking here.

A Look At The Impact Of Cadence Minerals' Dilution on Its 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. Zooming in to the last year, we still can't talk about growth rates coherently, since it made a loss last year. 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. Therefore, the dilution is having a noteworthy influence on shareholder returns.

If Cadence Minerals' 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.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Cadence Minerals' profit was boosted by unusual items worth UK£10m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And, after all, that's exactly what the accounting terminology implies. Cadence Minerals had a rather significant contribution from unusual items relative to its profit to December 2020. 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 Cadence Minerals' Profit Performance

In conclusion, Cadence Minerals' weak accrual ratio suggested its statutory earnings have been inflated by the unusual items. The dilution means the results are weaker when viewed from a per-share perspective. On reflection, the above-mentioned factors give us the strong impression that Cadence Minerals'underlying earnings power is not as good as it might seem, based on the statutory profit numbers. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. To that end, you should learn about the 5 warning signs we've spotted with Cadence Minerals (including 2 which are potentially serious).

Our examination of Cadence Minerals 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. 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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