We Think That There Are Issues Underlying Lloyds Steels Industries' (NSE:LSIL) Earnings

Despite posting some strong earnings, the market for Lloyds Steels Industries Limited's (NSE:LSIL) stock hasn't moved much. Our analysis suggests that shareholders have noticed something concerning in the numbers.

Our analysis indicates that LSIL is potentially overvalued!

Zooming In On Lloyds Steels Industries' 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). 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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to September 2022, Lloyds Steels Industries recorded an accrual ratio of 0.23. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Even though it reported a profit of ₹226.3m, a look at free cash flow indicates it actually burnt through ₹96m in the last year. We also note that Lloyds Steels Industries' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of ₹96m. Unfortunately for shareholders, the company has also been issuing new shares, diluting 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 Lloyds Steels Industries.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. In fact, Lloyds Steels Industries increased the number of shares on issue by 20% over the last twelve months by issuing new shares. Therefore, each share now receives a smaller portion of profit. To talk about net income, without noticing earnings per share, is to be distracted by the big numbers while ignoring the smaller numbers that talk to per share value. You can see a chart of Lloyds Steels Industries' EPS by clicking here.

A Look At The Impact Of Lloyds Steels Industries' Dilution On Its Earnings Per Share (EPS)

As you can see above, Lloyds Steels Industries has been growing its net income over the last few years, with an annualized gain of 822% over three years. And at a glance the 3,795% gain in profit over the last year impresses. On the other hand, earnings per share are only up 3,952% in that time. So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, earnings per share growth should beget share price growth. So Lloyds Steels Industries 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 Lloyds Steels Industries' Profit Performance

In conclusion, Lloyds Steels 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. For the reasons mentioned above, we think that a perfunctory glance at Lloyds Steels Industries' statutory profits might make it look better than it really is on an underlying level. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Be aware that Lloyds Steels Industries is showing 3 warning signs in our investment analysis and 1 of those is significant...

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 that insiders are buying 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.