Why Scope Industries Berhad's (KLSE:SCOPE) Earnings Are Weaker Than They Seem

Investors were disappointed with Scope Industries Berhad's (KLSE:SCOPE) recent earnings release. We did some digging and found some underlying numbers that are worrying.

See our latest analysis for Scope Industries Berhad

Zooming In On Scope Industries Berhad'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). 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. The ratio shows us how much a company's profit exceeds its FCF.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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 June 2021, Scope Industries Berhad had an accrual ratio of 0.22. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Even though it reported a profit of RM6.75m, a look at free cash flow indicates it actually burnt through RM17m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of RM17m, this year, indicates high risk. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings. The good news for shareholders is that Scope Industries 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 Scope Industries Berhad.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. Scope Industries Berhad expanded the number of shares on issue by 65% 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 Scope Industries Berhad's historical EPS growth by clicking on this link.

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

As it happens, we don't know how much the company made or lost three years ago, because we don't have the data. Zooming in to the last year, we still can't talk about growth rates coherently, since it made a loss last year. What we do know is that while it's great to see a profit over the last twelve months, that profit would have been better, on a per share basis, if the company hadn't needed to issue shares. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

If Scope Industries Berhad's EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. 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 Scope Industries Berhad's Profit Performance

In conclusion, Scope Industries Berhad has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means that shareholders now own a smaller proportion of the company (assuming they maintained the same number of shares). Considering all this we'd argue Scope Industries Berhad's profits probably give an overly generous impression of its sustainable level of profitability. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Our analysis shows 4 warning signs for Scope Industries Berhad (2 are significant!) and we strongly recommend you look at them 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. 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.
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