Sharda Motor Industries' (NSE:SHARDAMOTR) Solid Earnings May Rest On Weak Foundations

The stock price didn't jump after Sharda Motor Industries Limited (NSE:SHARDAMOTR) posted decent earnings last week. We did some digging and believe investors may be worried about some underlying factors in the report.

See our latest analysis for Sharda Motor Industries

Examining Cashflow Against Sharda Motor Industries' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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.

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

Sharda Motor Industries has an accrual ratio of 0.23 for the year to September 2024. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. To wit, it produced free cash flow of ₹2.6b during the period, falling well short of its reported profit of ₹3.20b. Given that Sharda Motor Industries had negative free cash flow in the prior corresponding period, the trailing twelve month resul of ₹2.6b would seem to be a step in the right direction. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

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

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by ₹553m, 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. Which is hardly surprising, given the name. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Sharda Motor Industries' Profit Performance

Sharda Motor Industries had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at Sharda Motor Industries' statutory profits might make it look better than it really is on an underlying level. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Our analysis shows 2 warning signs for Sharda Motor Industries (1 is concerning!) and we strongly recommend you look at these bad boys before investing.

Our examination of Sharda Motor Industries 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 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 with significant insider holdings to be useful.

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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.