We Believe Zuari Agro Chemicals' (NSE:ZUARI) Earnings Are A Poor Guide For Its Profitability

The latest earnings release from Zuari Agro Chemicals Limited (NSE:ZUARI ) disappointed investors. We did some digging and found some underlying numbers that are worrying.

Our analysis indicates that ZUARI is potentially undervalued!

Examining Cashflow Against Zuari Agro Chemicals' 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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. 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 2022, Zuari Agro Chemicals had an accrual ratio of 0.32. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. In the last twelve months it actually had negative free cash flow, with an outflow of ₹755m despite its profit of ₹9.42b, mentioned above. It's worth noting that Zuari Agro Chemicals generated positive FCF of ₹6.9b a year ago, so at least they've done it in the past. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio. One positive for Zuari Agro Chemicals shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

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

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Zuari Agro Chemicals' profit was boosted by unusual items worth ₹11b in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. 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. We can see that Zuari Agro Chemicals' positive unusual items were quite significant relative to its profit in the year to September 2022. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Zuari Agro Chemicals' Profit Performance

Zuari Agro Chemicals had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at Zuari Agro Chemicals' statutory profits might make it look better than it really is on an underlying level. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. For example, Zuari Agro Chemicals has 3 warning signs (and 2 which shouldn't be ignored) we think you should know about.

Our examination of Zuari Agro Chemicals 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 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.