Phantom Digital Effects' (NSE:PHANTOMFX) Profits May Be Overstating Its True Earnings Potential

Solid profit numbers didn't seem to be enough to please Phantom Digital Effects Limited's (NSE:PHANTOMFX) shareholders. Our analysis has found some concerning factors which weaken the profit's foundation.

View our latest analysis for Phantom Digital Effects

A Closer Look At Phantom Digital Effects' 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. 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 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to March 2024, Phantom Digital Effects had an accrual ratio of 0.92. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of ₹651m, in contrast to the aforementioned profit of ₹241.1m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of ₹651m, 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 Phantom Digital Effects.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. In fact, Phantom Digital Effects increased the number of shares on issue by 17% over the last twelve months by issuing new shares. Therefore, each share now receives a smaller portion of profit. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. You can see a chart of Phantom Digital Effects' EPS by clicking here.

How Is Dilution Impacting Phantom Digital Effects' Earnings Per Share (EPS)?

Phantom Digital Effects has improved its profit over the last three years, with an annualized gain of 32,010% in that time. And the 49% profit boost in the last year certainly seems impressive at first glance. But in comparison, EPS only increased by 68% over the same period. Therefore, the dilution is having a noteworthy influence on shareholder returns.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So it will certainly be a positive for shareholders if Phantom Digital Effects can grow EPS persistently. 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 Phantom Digital Effects' Profit Performance

As it turns out, Phantom Digital Effects couldn't match its profit with cashflow and its dilution means that earnings per share growth is lagging net income growth. Considering all this we'd argue Phantom Digital Effects' profits probably give an overly generous impression of its sustainable level of profitability. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Every company has risks, and we've spotted 4 warning signs for Phantom Digital Effects (of which 1 is significant!) you should know about.

Our examination of Phantom Digital Effects 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.

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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.