We Believe Apollo Micro Systems' (NSE:APOLLO) Earnings Are A Poor Guide For Its Profitability

Despite posting strong earnings, Apollo Micro Systems Limited's (NSE:APOLLO) stock didn't move much over the last week. We think that investors might be worried about the foundations the earnings are built on.

Check out our latest analysis for Apollo Micro Systems

Zooming In On Apollo Micro Systems' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. 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 March 2024, Apollo Micro Systems had an accrual ratio of 0.25. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Even though it reported a profit of ₹311.2m, a look at free cash flow indicates it actually burnt through ₹1.2b in the last year. We also note that Apollo Micro Systems' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of ₹1.2b. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. In fact, Apollo Micro Systems increased the number of shares on issue by 44% 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 Apollo Micro Systems' EPS by clicking here.

A Look At The Impact Of Apollo Micro Systems' Dilution On Its Earnings Per Share (EPS)

Apollo Micro Systems has improved its profit over the last three years, with an annualized gain of 203% in that time. In comparison, earnings per share only gained 151% over the same period. And at a glance the 66% gain in profit over the last year impresses. On the other hand, earnings per share are only up 37% in that time. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

In the long term, earnings per share growth should beget share price growth. So Apollo Micro Systems shareholders will want to see that EPS figure continue to increase. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

Our Take On Apollo Micro Systems' Profit Performance

As it turns out, Apollo Micro Systems couldn't match its profit with cashflow and its dilution means that earnings per share growth is lagging net income growth. Considering all this we'd argue Apollo Micro Systems' profits probably give an overly generous impression of its sustainable level of profitability. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. When we did our research, we found 2 warning signs for Apollo Micro Systems (1 doesn't sit too well with us!) that we believe deserve your full attention.

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 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.