Thermax's (NSE:THERMAX) Shareholders Should Assess Earnings With Caution

The latest earnings release from Thermax Limited (NSE:THERMAX ) disappointed investors. We did some digging and found some underlying numbers that are worrying.

View our latest analysis for Thermax

Examining Cashflow Against Thermax's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. 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 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. 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, Thermax recorded an accrual ratio of 0.37. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. In the last twelve months it actually had negative free cash flow, with an outflow of ₹3.3b despite its profit of ₹7.42b, mentioned above. We also note that Thermax's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of ₹3.3b. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

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.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Thermax's profit was boosted by unusual items worth ₹1.3b in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. 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 Thermax 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 Thermax's Profit Performance

Summing up, Thermax 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 Thermax's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Thermax as a business, it's important to be aware of any risks it's facing. To that end, you should learn about the 2 warning signs we've spotted with Thermax (including 1 which is a bit concerning).

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 with significant insider holdings 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.