SRM Contractors' (NSE:SRM) Promising Earnings May Rest On Soft Foundations

SRM Contractors Limited (NSE:SRM) just reported some strong earnings, and the market reacted accordingly with a healthy uplift in the share price. However, our analysis suggests that shareholders may be missing some factors that indicate the earnings result was not as good as it looked.

View our latest analysis for SRM Contractors

Zooming In On SRM Contractors' 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. 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.

SRM Contractors has an accrual ratio of 0.84 for the year to September 2024. 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 ₹258.8m, a look at free cash flow indicates it actually burnt through ₹1.0b in the last year. It's worth noting that SRM Contractors generated positive FCF of ₹42m a year ago, so at least they've done it in the past.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of SRM Contractors.

Our Take On SRM Contractors' Profit Performance

As we have made quite clear, we're a bit worried that SRM Contractors didn't back up the last year's profit with free cashflow. As a result, we think it may well be the case that SRM Contractors' underlying earnings power is lower than its statutory profit. But on the bright side, its earnings per share have grown at an extremely impressive rate over the last three years. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For example, SRM Contractors has 2 warning signs (and 1 which can't be ignored) we think you should know about.

This note has only looked at a single factor that sheds light on the nature of SRM Contractors' 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 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.