Shareholders Shouldn’t Be Too Comfortable With Azad Engineering's (NSE:AZAD) Strong Earnings

We didn't see Azad Engineering Limited's (NSE:AZAD) stock surge when it reported robust earnings recently. We think that investors might be worried about the foundations the earnings are built on.

View our latest analysis for Azad Engineering

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

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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".

Over the twelve months to September 2024, Azad Engineering recorded an accrual ratio of 0.33. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. Even though it reported a profit of ₹698.2m, a look at free cash flow indicates it actually burnt through ₹1.8b in the last year. We also note that Azad Engineering's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of ₹1.8b. 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.

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.

How Do Unusual Items Influence Profit?

On top of the noteworthy accrual ratio and the spike in non-operating revenue, we can also see that Azad Engineering benefitted from unusual items worth ₹259m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. 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 that's as you'd expect, given these boosts are described as 'unusual'. If Azad Engineering doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Azad Engineering's Profit Performance

Summing up, Azad Engineering received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Azad Engineering's profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Azad Engineering at this point in time. For example - Azad Engineering has 1 warning sign we think you should be aware of.

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 are plenty of other ways to inform your opinion of a company. 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks with high insider ownership.

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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.