Are Kothari Petrochemicals's (NSE:KOTHARIPET) Statutory Earnings A Good Reflection Of Its Earnings Potential?

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. 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 Kothari Petrochemicals' (NSE:KOTHARIPET) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Kothari Petrochemicals made a profit of ₹157.3m on revenue of ₹2.28b. Happily, it has grown both its profit and revenue over the last three years (though we note its revenue is down over the last year).

See our latest analysis for Kothari Petrochemicals

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. Today, we'll discuss Kothari Petrochemicals' free cashflow relative to its earnings, and consider what that tells us about the company. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Kothari Petrochemicals.

A Closer Look At Kothari Petrochemicals' 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. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. 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. 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 2020, Kothari Petrochemicals recorded an accrual ratio of -0.12. That indicates that its free cash flow was a fair bit more than its statutory profit. To wit, it produced free cash flow of ₹279m during the period, dwarfing its reported profit of ₹157.3m. Kothari Petrochemicals' free cash flow improved over the last year, which is generally good to see.

Our Take On Kothari Petrochemicals' Profit Performance

Kothari Petrochemicals' accrual ratio is solid, and indicates strong free cash flow, as we discussed, above. Based on this observation, we consider it likely that Kothari Petrochemicals' statutory profit actually understates its earnings potential! And on top of that, its earnings per share have grown at an extremely impressive rate over the last three years. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So while earnings quality is important, it's equally important to consider the risks facing Kothari Petrochemicals at this point in time. Case in point: We've spotted 1 warning sign for Kothari Petrochemicals you should be aware of.

Today we've zoomed in on a single data point to better understand the nature of Kothari Petrochemicals' 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. 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. 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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