Balu Forge Industries' (NSE:BALUFORGE) Shareholders Should Assess Earnings With Caution

Despite posting strong earnings, Balu Forge Industries Limited's (NSE:BALUFORGE) stock didn't move much over the last week. We decided to have a deeper look, and we believe that investors might be worried about several concerning factors that we found.

Check out our latest analysis for Balu Forge Industries

Examining Cashflow Against Balu Forge 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. 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 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.

For the year to March 2024, Balu Forge Industries had an accrual ratio of 0.69. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of ₹1.7b, in contrast to the aforementioned profit of ₹936.7m. It's worth noting that Balu Forge Industries generated positive FCF of ₹49m a year ago, so at least they've done it in the past. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings.

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

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Balu Forge Industries issued 23% more new shares over the last year. As a result, its net income is now split between a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. Check out Balu Forge Industries' historical EPS growth by clicking on this link.

How Is Dilution Impacting Balu Forge Industries' Earnings Per Share (EPS)?

As you can see above, Balu Forge Industries has been growing its net income over the last few years, with an annualized gain of 1,130% over three years. But EPS was only up 359% per year, in the exact same period. And at a glance the 141% gain in profit over the last year impresses. But in comparison, EPS only increased by 110% over the same period. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So it will certainly be a positive for shareholders if Balu Forge Industries can grow EPS persistently. 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.

Our Take On Balu Forge Industries' Profit Performance

In conclusion, Balu Forge Industries has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means its earnings per share growth is weaker than its profit growth. Considering all this we'd argue Balu Forge Industries' 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 Balu Forge Industries at this point in time. For example, Balu Forge Industries has 3 warning signs (and 2 which are a bit concerning) we think you should know about.

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.