Reach Subsea's (OB:REACH) Performance Is Even Better Than Its Earnings Suggest

Reach Subsea ASA (OB:REACH) recently posted some strong earnings, and the market responded positively. We did some digging and found some further encouraging factors that investors will like.

View our latest analysis for Reach Subsea

Zooming In On Reach Subsea'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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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".

Over the twelve months to December 2023, Reach Subsea recorded an accrual ratio of -1.12. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of kr750m during the period, dwarfing its reported profit of kr225.8m. Reach Subsea shareholders are no doubt pleased that free cash flow improved over the last twelve months. 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.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. Reach Subsea expanded the number of shares on issue by 20% over the last year. As a result, its net income is now split between a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. You can see a chart of Reach Subsea's EPS by clicking here.

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

As you can see above, Reach Subsea has been growing its net income over the last few years, with an annualized gain of 424% over three years. In comparison, earnings per share only gained 196% over the same period. And the 213% profit boost in the last year certainly seems impressive at first glance. On the other hand, earnings per share are only up 155% in that time. And so, you can see quite clearly that dilution is influencing shareholder earnings.

In the long term, earnings per share growth should beget share price growth. So it will certainly be a positive for shareholders if Reach Subsea can grow EPS persistently. 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 Reach Subsea's Profit Performance

At the end of the day, Reach Subsea is diluting shareholders which will dampen earnings per share growth, but its accrual ratio showed it can back up its profits with free cash flow. Considering all the aforementioned, we'd venture that Reach Subsea's profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. 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. In terms of investment risks, we've identified 2 warning signs with Reach Subsea, and understanding these bad boys should be part of your investment process.

Our examination of Reach Subsea has focussed on certain factors that can make its earnings look better than they are. 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. 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.