We Think That There Are More Issues For Neogen Chemicals (NSE:NEOGEN) Than Just Sluggish Earnings

Neogen Chemicals Limited's (NSE:NEOGEN) recent weak earnings report didn't cause a big stock movement. We think that investors are worried about some weaknesses underlying the earnings.

View our latest analysis for Neogen Chemicals

A Closer Look At Neogen Chemicals' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to March 2024, Neogen Chemicals recorded an accrual ratio of 0.39. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. In the last twelve months it actually had negative free cash flow, with an outflow of ₹3.3b despite its profit of ₹356.5m, mentioned above. We also note that Neogen Chemicals' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of ₹3.3b. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings.

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.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. Neogen Chemicals expanded the number of shares on issue by 5.8% over the last year. As a result, its net income is now split between a greater number of shares. To talk about net income, without noticing earnings per share, is to be distracted by the big numbers while ignoring the smaller numbers that talk to per share value. You can see a chart of Neogen Chemicals' EPS by clicking here.

A Look At The Impact Of Neogen Chemicals' Dilution On Its Earnings Per Share (EPS)

As you can see above, Neogen Chemicals has been growing its net income over the last few years, with an annualized gain of 14% over three years. Net profit actually dropped by 29% in the last year. But the EPS result was even worse, with the company recording a decline of 30%. Therefore, the dilution is having a noteworthy influence on shareholder returns.

In the long term, if Neogen Chemicals' earnings per share can increase, then the share price should too. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

Our Take On Neogen Chemicals' Profit Performance

In conclusion, Neogen Chemicals has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means that shareholders now own a smaller proportion of the company (assuming they maintained the same number of shares). Considering all this we'd argue Neogen Chemicals' profits probably give an overly generous impression of its sustainable level of profitability. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. To help with this, we've discovered 3 warning signs (2 are a bit unpleasant!) that you ought to be aware of before buying any shares in Neogen Chemicals.

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.