Smartlink Holdings' (NSE:SMARTLINK) Profits Appear To Have Quality Issues

The recent earnings posted by Smartlink Holdings Limited (NSE:SMARTLINK) were solid, but the stock didn't move as much as we expected. However the statutory profit number doesn't tell the whole story, and we have found some factors which might be of concern to shareholders.

View our latest analysis for Smartlink Holdings

Zooming In On Smartlink Holdings' Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to September 2021, Smartlink Holdings had an accrual ratio of -0.14. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of ₹353m, well over the ₹95.5m it reported in profit. Smartlink Holdings did see its free cash flow drop year on year, which is less than ideal, like a Simpson's episode without Groundskeeper Willie. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio).

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

How Do Unusual Items Influence Profit?

Surprisingly, given Smartlink Holdings' accrual ratio implied strong cash conversion, its paper profit was actually boosted by ₹21m in unusual items. 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. And, after all, that's exactly what the accounting terminology implies. Smartlink Holdings had a rather significant contribution from unusual items relative to its profit to September 2021. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Smartlink Holdings profited from a tax benefit which contributed ₹24m to profit. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. The receipt of a tax benefit is obviously a good thing, on its own. And since it previously lost money, it may well simply indicate the realisation of past tax losses. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth. While we think it's good that the company has booked a tax benefit, it does mean that there's every chance the statutory profit will come in a lot higher than it would be if the income was adjusted for one-off factors.

Our Take On Smartlink Holdings' Profit Performance

Summing up, Smartlink Holdings' accrual ratio suggests that its statutory earnings are well matched by free cash flow while its unusual items and tax benefit is boosted profit in a way that may not be sustained. For the reasons mentioned above, we think that a perfunctory glance at Smartlink Holdings' statutory profits might make it look better than it really is on an underlying level. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. While conducting our analysis, we found that Smartlink Holdings has 2 warning signs and it would be unwise to ignore them.

Our examination of Smartlink Holdings 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. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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.

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.

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