Shareholders Shouldn’t Be Too Comfortable With Zen Technologies' (NSE:ZENTEC) Strong Earnings

The latest earnings release from Zen Technologies Limited (NSE:ZENTEC ) disappointed investors. Our analysis found several concerning factors in the earnings report beyond the strong statutory profit number.

See our latest analysis for Zen Technologies

A Closer Look At Zen Technologies' 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. 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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 March 2024, Zen Technologies had an accrual ratio of 0.60. 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. In the last twelve months it actually had negative free cash flow, with an outflow of ₹167m despite its profit of ₹1.28b, mentioned above. We saw that FCF was ₹1.0b a year ago though, so Zen Technologies has at least been able to generate positive FCF in the past. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings. The good news for shareholders is that Zen Technologies' accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. 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 Zen Technologies.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. Zen Technologies expanded the number of shares on issue by 5.7% over the last year. Therefore, each share now receives a smaller portion of profit. 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 Zen Technologies' historical EPS growth by clicking on this link.

How Is Dilution Impacting Zen Technologies' Earnings Per Share (EPS)?

As you can see above, Zen Technologies has been growing its net income over the last few years, with an annualized gain of 4,010% over three years. But EPS was only up 3,848% per year, in the exact same period. And at a glance the 199% gain in profit over the last year impresses. But in comparison, EPS only increased by 186% over the same period. So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, earnings per share growth should beget share price growth. So Zen Technologies shareholders will want to see that EPS figure continue to increase. 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 Zen Technologies' Profit Performance

As it turns out, Zen Technologies couldn't match its profit with cashflow and its dilution means that earnings per share growth is lagging net income growth. For the reasons mentioned above, we think that a perfunctory glance at Zen Technologies' statutory profits might make it look better than it really is on an underlying level. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Every company has risks, and we've spotted 2 warning signs for Zen Technologies (of which 1 is potentially serious!) you should know about.

Our examination of Zen Technologies 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.

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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.