Here's Why National Fertilizers's (NSE:NFL) Statutory Earnings Are Arguably Too Conservative

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. That said, the current statutory profit is not always a good guide to a company's underlying profitability. Today we'll focus on whether this year's statutory profits are a good guide to understanding National Fertilizers (NSE:NFL).

While National Fertilizers was able to generate revenue of ₹128.1b in the last twelve months, we think its profit result of ₹521.8m was more important. The chart below shows how it has grown revenue over the last three years, but that profit has declined.

View our latest analysis for National Fertilizers

Not all profits are equal, and we can learn more about the nature of a company's past profitability by diving deeper into the financial statements. So today we'll look at what National Fertilizers' cashflow and unusual items tell us about the quality of its earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of National Fertilizers.

A Closer Look At National Fertilizers' 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. 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. The ratio shows us how much a company's profit exceeds its FCF.

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".

National Fertilizers has an accrual ratio of -0.13 for the year to September 2020. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. Indeed, in the last twelve months it reported free cash flow of ₹11b, well over the ₹521.8m it reported in profit. Given that National Fertilizers had negative free cash flow in the prior corresponding period, the trailing twelve month resul of ₹11b would seem to be a step in the right direction. 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.

How Do Unusual Items Influence Profit?

National Fertilizers' profit was reduced by unusual items worth ₹3.9b in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. National Fertilizers took a rather significant hit from unusual items in the year to September 2020. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.

Our Take On National Fertilizers' Profit Performance

In conclusion, both National Fertilizers' accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. After considering all this, we reckon National Fertilizers' statutory profit probably understates its earnings potential! So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Our analysis shows 5 warning signs for National Fertilizers (1 can't be ignored!) and we strongly recommend you look at these before investing.

Our examination of National Fertilizers has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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. 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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