We didn't see Annum Berhad's (KLSE:ANNUM) stock surge when it reported robust earnings recently. We think that investors might be worried about the foundations the earnings are built on.
A Closer Look At Annum Berhad'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. 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.
As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.
For the year to March 2021, Annum Berhad had an accrual ratio of 0.25. 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 RM538k, which is significantly less than its profit of RM13.3m. Given that Annum Berhad had negative free cash flow in the prior corresponding period, the trailing twelve month resul of RM538k would seem to be a step in the right direction. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio. The good news for shareholders is that Annum Berhad's 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. As a result, some shareholders may be looking for stronger cash conversion in the current year.
Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Annum Berhad.
How Do Unusual Items Influence Profit?
Given the accrual ratio, it's not overly surprising that Annum Berhad's profit was boosted by unusual items worth RM8.2m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. 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. Annum 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.
An Unusual Tax Situation
Moving on from the accrual ratio, we note that Annum Berhad profited from a tax benefit which contributed RM853k to profit. This is meaningful because companies usually pay tax rather than receive tax benefits. The receipt of a tax benefit is obviously a good thing, on its own. And given that it lost money last year, it seems possible that the benefit is evidence that it now expects to find value in its past tax losses. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal.
Our Take On Annum Berhad's Profit Performance
Summing up, Annum Berhad's tax benefit and unusual items boosted its statutory profit leading to poor cash conversion, as reflected by its accrual ratio. On reflection, the above-mentioned factors give us the strong impression that Annum Berhad'sunderlying earnings power is not as good as it might seem, based on the statutory profit numbers. So while earnings quality is important, it's equally important to consider the risks facing Annum Berhad at this point in time. For example, Annum Berhad has 4 warning signs (and 1 which is a bit unpleasant) we think you should know about.
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 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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