Hindustan Foods (NSE:HNDFDS) Is Growing Earnings But Are They A Good Guide?

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. This article will consider whether Hindustan Foods' (NSE:HNDFDS) statutory profits are a good guide to its underlying earnings.

We like the fact that Hindustan Foods made a profit of ₹246.6m on its revenue of ₹9.75b, in the last year. At the risk of seeming quaint, we do like to at least examine profit, even when a stock is improving revenue and considered a 'growth stock'. Happily, it has grown both its profit and revenue over the last three years, as you can see in the chart below.

Check out our latest analysis for Hindustan Foods

Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. So today we'll examine what Hindustan Foods' cashflow and its expanding share count tell us about the nature of its profits. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Hindustan Foods.

A Closer Look At Hindustan Foods' Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. 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".

For the year to September 2020, Hindustan Foods had an accrual ratio of 0.40. 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. Even though it reported a profit of ₹246.6m, a look at free cash flow indicates it actually burnt through ₹820m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of ₹820m, this year, indicates high risk. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. Hindustan Foods expanded the number of shares on issue by 57% over the last year. As a result, its net income is now split between a greater number of shares. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. Check out Hindustan Foods' historical EPS growth by clicking on this link.

A Look At The Impact Of Hindustan Foods' Dilution on Its Earnings Per Share (EPS).

As you can see above, Hindustan Foods has been growing its net income over the last few years, with an annualized gain of 572% over three years. But EPS was only up 285% per year, in the exact same period. And at a glance the 97% gain in profit over the last year impresses. But in comparison, EPS only increased by 30% over the same period. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So it will certainly be a positive for shareholders if Hindustan Foods can grow EPS persistently. 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.

Our Take On Hindustan Foods' Profit Performance

As it turns out, Hindustan Foods couldn't match its profit with cashflow and its dilution means that earnings per share growth is lagging net income growth. For the reasons mentioned above, we think that a perfunctory glance at Hindustan Foods' statutory profits might make it look better than it really is on an underlying level. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For instance, we've identified 4 warning signs for Hindustan Foods (3 are concerning) you should be familiar with.

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. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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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