Reliance Power's (NSE:RPOWER) Earnings Are Of Questionable Quality

Unsurprisingly, Reliance Power Limited's (NSE:RPOWER) stock price was strong on the back of its healthy earnings report. We did some analysis and think that investors are missing some details hidden beneath the profit numbers.

Check out our latest analysis for Reliance Power

Zooming In On Reliance Power's 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to March 2021, Reliance Power recorded an accrual ratio of -0.10. That indicates that its free cash flow was a fair bit more than its statutory profit. To wit, it produced free cash flow of ₹40b during the period, dwarfing its reported profit of ₹2.02b. Reliance Power's free cash flow improved over the last year, which is generally good to see. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

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

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Reliance Power's profit was boosted by unusual items worth ₹2.9b in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. Which is hardly surprising, given the name. If Reliance Power doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Reliance Power's Profit Performance

Reliance Power's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Based on these factors, it's hard to tell if Reliance Power's profits are a reasonable reflection of its underlying profitability. 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. When we did our research, we found 3 warning signs for Reliance Power (1 is a bit unpleasant!) that we believe deserve your full attention.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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. 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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