NorAm Drilling's (OB:NORAM) Solid Profits Have Weak Fundamentals

NorAm Drilling AS (OB:NORAM) announced strong profits, but the stock was stagnant. Our analysis suggests that shareholders have noticed something concerning in the numbers.

View our latest analysis for NorAm Drilling

Examining Cashflow Against NorAm Drilling's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. 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. 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 December 2022, NorAm Drilling had an accrual ratio of -0.10. Therefore, its statutory earnings were quite a lot less than its free cashflow. To wit, it produced free cash flow of US$13m during the period, dwarfing its reported profit of US$2.98m. Notably, NorAm Drilling had negative free cash flow last year, so the US$13m it produced this year was a welcome improvement. 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. NorAm Drilling expanded the number of shares on issue by 79% 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. You can see a chart of NorAm Drilling's EPS by clicking here.

A Look At The Impact Of NorAm Drilling's Dilution On Its Earnings Per Share (EPS)

NorAm Drilling was losing money three years ago. And even focusing only on the last twelve months, we don't have a meaningful growth rate because it made a loss a year ago, too. But mathematics aside, it is always good to see when a formerly unprofitable business come good (though we accept profit would have been higher if dilution had not been required). Therefore, one can observe that the dilution is having a fairly profound effect on shareholder returns.

In the long term, if NorAm Drilling's earnings per share can increase, then the share price should too. 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 NorAm Drilling's Profit Performance

In conclusion, NorAm Drilling has a strong cashflow relative to earnings, which indicates good quality earnings, but the dilution means its earnings per share are dropping faster than its profit. Based on these factors, we think it's very unlikely that NorAm Drilling's statutory profits make it seem much weaker than it is. So while earnings quality is important, it's equally important to consider the risks facing NorAm Drilling at this point in time. At Simply Wall St, we found 1 warning sign for NorAm Drilling and we think they deserve your 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 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. 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.