Is There More To The Story Than De Nora India's (NSE:DENORA) Earnings Growth?

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. That said, the current statutory profit is not always a good guide to a company's underlying profitability. Today we'll focus on whether this year's statutory profits are a good guide to understanding De Nora India (NSE:DENORA).

It's good to see that over the last twelve months De Nora India made a profit of ₹77.3m on revenue of ₹481.9m. One positive is that it has grown both its profit and its revenue, over the last few years.

View our latest analysis for De Nora India

Not all profits are equal, and we can learn more about the nature of a company's past profitability by diving deeper into the financial statements. As a result, we think it's well worth considering what De Nora India's cashflow (when compared to its earnings) can tell us about the nature of its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of De Nora India.

A Closer Look At De Nora India's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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. The ratio shows us how much a company's profit exceeds its FCF.

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".

De Nora India has an accrual ratio of 0.57 for the year to September 2020. 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. Even though it reported a profit of ₹77.3m, a look at free cash flow indicates it actually burnt through ₹95m in the last year. It's worth noting that De Nora India generated positive FCF of ₹36m a year ago, so at least they've done it in the past. The good news for shareholders is that De Nora India'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.

Our Take On De Nora India's Profit Performance

As we have made quite clear, we're a bit worried that De Nora India didn't back up the last year's profit with free cashflow. As a result, we think it may well be the case that De Nora India's underlying earnings power is lower than its statutory profit. But the good news is that its EPS growth over the last three years has been very impressive. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So while earnings quality is important, it's equally important to consider the risks facing De Nora India at this point in time. For example, we've found that De Nora India has 3 warning signs (2 are a bit concerning!) that deserve your attention before going any further with your analysis.

This note has only looked at a single factor that sheds light on the nature of De Nora India's profit. But there are plenty of other ways to inform your opinion of a company. Some people consider a high return on equity to be a good sign of a quality business. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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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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