Imagicaaworld Entertainment's (NSE:IMAGICAA) Robust Earnings Are Not All Good News For Shareholders

Strong earnings weren't enough to please Imagicaaworld Entertainment Limited's (NSE:IMAGICAA) shareholders over the last week. We did some digging and found some underlying numbers that are worrying.

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Examining Cashflow Against Imagicaaworld Entertainment'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). 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.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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".

Imagicaaworld Entertainment has an accrual ratio of 0.72 for the year to September 2022. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. In fact, it had free cash flow of ₹279m in the last year, which was a lot less than its statutory profit of ₹4.20b. We note, however, that Imagicaaworld Entertainment grew its free cash flow over the last year. However, that's not the end of the story. We must also consider the impact of unusual items on statutory profit (and thus the accrual ratio), as well as note the ramifications of the company issuing new shares. The good news for shareholders is that Imagicaaworld Entertainment'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.

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

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. In fact, Imagicaaworld Entertainment increased the number of shares on issue by 367% over the last twelve months by issuing new shares. 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. You can see a chart of Imagicaaworld Entertainment's EPS by clicking here.

A Look At The Impact Of Imagicaaworld Entertainment's Dilution On Its Earnings Per Share (EPS)

Imagicaaworld Entertainment was losing money three years ago. And even focusing only on the last twelve months, we don't have a meaningful growth rate because it made a loss a year ago, too. What we do know is that while it's great to see a profit over the last twelve months, that profit would have been better, on a per share basis, if the company hadn't needed to issue shares. Therefore, one can observe that the dilution is having a fairly profound effect on shareholder returns.

If Imagicaaworld Entertainment's EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For that reason, you could say that EPS is more important that net income in the long run, assuming the goal is to assess whether a company's share price might grow.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Imagicaaworld Entertainment's profit was boosted by unusual items worth ₹4.9b in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. We can see that Imagicaaworld Entertainment's positive unusual items were quite significant relative to its profit in the year to September 2022. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Imagicaaworld Entertainment's Profit Performance

Imagicaaworld Entertainment didn't back up its earnings with free cashflow, but this isn't too surprising given profits were inflated by unusual items. The dilution means the results are weaker when viewed from a per-share perspective. For all the reasons mentioned above, we think that, at a glance, Imagicaaworld Entertainment's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. If you want to do dive deeper into Imagicaaworld Entertainment, you'd also look into what risks it is currently facing. To help with this, we've discovered 4 warning signs (3 are concerning!) that you ought to be aware of before buying any shares in Imagicaaworld Entertainment.

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.