We Don’t Think Lotus KFM Berhad's (KLSE:LOTUS) Earnings Should Make Shareholders Too Comfortable

Solid profit numbers didn't seem to be enough to please Lotus KFM Berhad's (KLSE:LOTUS) shareholders. Our analysis suggests they may be concerned about some underlying details.

View our latest analysis for Lotus KFM Berhad

A Closer Look At Lotus KFM Berhad's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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.

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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. 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 March 2021, Lotus KFM Berhad had an accrual ratio of 0.61. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Over the last year it actually had negative free cash flow of RM9.1m, in contrast to the aforementioned profit of RM5.50m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of RM9.1m, this year, indicates high risk. However, that's not the end of the story. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Lotus KFM Berhad.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. As it happens, Lotus KFM Berhad issued 48% more new shares over the last year. As a result, its net income is now split between a greater number of shares. 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 Lotus KFM Berhad's historical EPS growth by clicking on this link.

A Look At The Impact Of Lotus KFM Berhad's Dilution on Its Earnings Per Share (EPS).

Lotus KFM Berhad was losing money three years ago. On the bright side, in the last twelve months it grew profit by 81%. But EPS was far less impressive, dropping 30% in that time. This shows how dangerous it is to rely on net income alone, when measuring growth. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

If Lotus KFM Berhad's EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. 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.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by RM5.0m, in the last year, probably goes some way to explain why its accrual ratio was so weak. 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. And that's as you'd expect, given these boosts are described as 'unusual'. Lotus KFM Berhad had a rather significant contribution from unusual items relative to its profit to March 2021. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Lotus KFM Berhad's Profit Performance

In conclusion, Lotus KFM Berhad's weak accrual ratio suggested its statutory earnings have been inflated by the unusual items. The dilution means the results are weaker when viewed from a per-share perspective. For all the reasons mentioned above, we think that, at a glance, Lotus KFM Berhad's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Our analysis shows 3 warning signs for Lotus KFM Berhad (1 doesn't sit too well with us!) and we strongly recommend you look at these bad boys before investing.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. But there are plenty of other ways to inform your opinion of a company. Some people consider a high return on equity to be a good sign of a quality business. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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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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