Mahanagar Gas' (NSE:MGL) Shareholders Have More To Worry About Than Only Soft Earnings

The subdued market reaction suggests that Mahanagar Gas Limited's (NSE:MGL) recent earnings didn't contain any surprises. Our analysis suggests that along with soft profit numbers, investors should be aware of some other underlying weaknesses in the numbers.

Our analysis indicates that MGL is potentially undervalued!

Zooming In On Mahanagar Gas' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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.

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 September 2022, Mahanagar Gas had an accrual ratio of 0.26. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Indeed, in the last twelve months it reported free cash flow of ₹160m, which is significantly less than its profit of ₹5.38b. Mahanagar Gas shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months.

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

Our Take On Mahanagar Gas' Profit Performance

Mahanagar Gas didn't convert much of its profit to free cash flow in the last year, which some investors may consider rather suboptimal. Therefore, it seems possible to us that Mahanagar Gas' true underlying earnings power is actually less than its statutory profit. Sadly, its EPS was down over the last twelve months. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example, we've found that Mahanagar Gas has 3 warning signs (1 can't be ignored!) that deserve your attention before going any further with your analysis.

This note has only looked at a single factor that sheds light on the nature of Mahanagar Gas' profit. But there are plenty of other ways to inform your opinion of a company. 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.