Solid Earnings May Not Tell The Whole Story For Circle (BIT:CIRC)

The market shrugged off Circle S.p.A.'s (BIT:CIRC) solid earnings report. We did some digging and believe investors may be worried about some underlying factors in the report.

We've discovered 4 warning signs about Circle. View them for free.

A Closer Look At Circle's 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). The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. 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. 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 December 2024, Circle had an accrual ratio of 0.24. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Over the last year it actually had negative free cash flow of €1.3m, in contrast to the aforementioned profit of €1.41m. We also note that Circle's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of €1.3m. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Circle issued 19% more new shares over the last year. As a result, its net income is now split between a greater number of shares. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. You can see a chart of Circle's EPS by clicking here.

How Is Dilution Impacting Circle's Earnings Per Share (EPS)?

As you can see above, Circle has been growing its net income over the last few years, with an annualized gain of 295% over three years. In comparison, earnings per share only gained over the same period. However, net income was pretty flat over the last year with a miniscule increase. Earnings per share are pretty much flat, too over the last twelve months, but EPS growth came in below below net income growth. Therefore, the dilution is having a noteworthy influence on shareholder returns.

In the long term, earnings per share growth should beget share price growth. So Circle 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 that reason, you could say that EPS is more important that net income in the long run, assuming the goal is to assess whether a company's share price might grow.

Our Take On Circle's Profit Performance

In conclusion, Circle has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means its earnings per share growth is weaker than its profit growth. For the reasons mentioned above, we think that a perfunctory glance at Circle's statutory profits might make it look better than it really is on an underlying level. 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. To that end, you should learn about the 4 warning signs we've spotted with Circle (including 1 which doesn't sit too well with us).

Our examination of Circle 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.