Here's Why We Don't Think Pasal Real Estate Development's (ATH:PASAL) Statutory Earnings Reflect Its Underlying Earnings Potential

Broadly speaking, profitable businesses are less risky than unprofitable ones. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. This article will consider whether Pasal Real Estate Development's (ATH:PASAL) statutory profits are a good guide to its underlying earnings.

While Pasal Real Estate Development was able to generate revenue of €1.64m in the last twelve months, we think its profit result of €44.0m was more important. The chart below shows that while revenue has fallen over the last three years, the company has moved from unprofitable to profitable.

See our latest analysis for Pasal Real Estate Development

Importantly, statutory profits are not always the best tool for understanding a company's true earnings power, so it's well worth examining profits in a little more detail. So today we'll look at what Pasal Real Estate Development's cashflow and unusual items tell us about the quality of its earnings, as well as touching on how its recent share issues are impacting shareholders. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Pasal Real Estate Development.

Zooming In On Pasal Real Estate Development'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. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. 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 June 2020, Pasal Real Estate Development had an accrual ratio of 0.94. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. In the last twelve months it actually had negative free cash flow, with an outflow of €80k despite its profit of €44.0m, mentioned above. We saw that FCF was €1.3m a year ago though, so Pasal Real Estate Development has at least been able to generate positive FCF in the past. Having said that, there is more to consider. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively. The good news for shareholders is that Pasal Real Estate Development's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. As it happens, Pasal Real Estate Development issued 800% more new shares over the last year. Therefore, each share now receives a smaller portion of profit. 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. Check out Pasal Real Estate Development's historical EPS growth by clicking on this link.

How Is Dilution Impacting Pasal Real Estate Development's Earnings Per Share? (EPS)

Three years ago, Pasal Real Estate Development lost money. 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. So you can see that the dilution has had a fairly significant impact on shareholders.

In the long term, if Pasal Real Estate Development's earnings per share can increase, then the share price should too. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. 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.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by €42m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. 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. Pasal Real Estate Development had a rather significant contribution from unusual items relative to its profit to June 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 Pasal Real Estate Development's Profit Performance

In conclusion, Pasal Real Estate Development's weak accrual ratio suggested its statutory earnings have been inflated by the unusual items. Meanwhile, the new shares issued mean that shareholders now own less of the company, unless they tipped in more cash themselves. On reflection, the above-mentioned factors give us the strong impression that Pasal Real Estate Development'sunderlying earnings power is not as good as it might seem, based on the statutory profit numbers. If you'd like to know more about Pasal Real Estate Development as a business, it's important to be aware of any risks it's facing. Our analysis shows 6 warning signs for Pasal Real Estate Development (3 shouldn't be ignored!) and we strongly recommend you look at them 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. 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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