We Believe That Pakka's (NSE:PAKKA) Weak Earnings Are A Good Indicator Of Underlying Profitability

Pakka Limited's (NSE:PAKKA) stock wasn't much affected by its recent lackluster earnings numbers. Our analysis suggests that they may be missing some concerning details underlying the profit numbers.

View our latest analysis for Pakka

A Closer Look At Pakka's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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. 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.

For the year to September 2024, Pakka had an accrual ratio of 0.37. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. In the last twelve months it actually had negative free cash flow, with an outflow of ₹878m despite its profit of ₹434.3m, mentioned above. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of ₹878m, this year, indicates high risk. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Pakka.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. Pakka expanded the number of shares on issue by 14% over the last year. That means its earnings are split among 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. Check out Pakka's historical EPS growth by clicking on this link.

How Is Dilution Impacting Pakka's Earnings Per Share (EPS)?

As you can see above, Pakka has been growing its net income over the last few years, with an annualized gain of 40% over three years. In comparison, earnings per share only gained 26% over the same period. Net profit actually dropped by 15% in the last year. Unfortunately for shareholders, though, the earnings per share result was even worse, declining 18%. Therefore, the dilution is having a noteworthy influence on shareholder returns.

If Pakka's EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. 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 Pakka's Profit Performance

As it turns out, Pakka couldn't match its profit with cashflow and its dilution means that shareholders own less of the company than the did before (unless they bought more shares). For the reasons mentioned above, we think that a perfunctory glance at Pakka's statutory profits might make it look better than it really is on an underlying level. So while earnings quality is important, it's equally important to consider the risks facing Pakka at this point in time. Be aware that Pakka is showing 2 warning signs in our investment analysis and 1 of those is significant...

Our examination of Pakka has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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 with significant insider holdings to be useful.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.