Birla's (NSE:BIRLACORPN) Weak Earnings May Only Reveal A Part Of The Whole Picture

A lackluster earnings announcement from Birla Corporation Limited (NSE:BIRLACORPN) last week didn't sink the stock price. We think that investors are worried about some weaknesses underlying the earnings.

Check out our latest analysis for Birla

Zooming In On Birla'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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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 2023, Birla recorded an accrual ratio of -0.10. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. In fact, it had free cash flow of ₹12b in the last year, which was a lot more than its statutory profit of ₹1.53b. Notably, Birla had negative free cash flow last year, so the ₹12b it produced this year was a welcome improvement. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

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.

How Do Unusual Items Influence Profit?

Surprisingly, given Birla's accrual ratio implied strong cash conversion, its paper profit was actually boosted by ₹847m in unusual items. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. Which is hardly surprising, given the name. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Birla's Profit Performance

Birla's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Based on these factors, we think it's very unlikely that Birla's statutory profits make it seem much weaker than it is. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Our analysis shows 2 warning signs for Birla (1 is concerning!) and we strongly recommend you look at these before investing.

Our examination of Birla has focussed on certain factors that can make its earnings look better than they are. 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. 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. 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.