Shareholders In New Zealand Oil & Gas (NZSE:NZO) Should Look Beyond Earnings For The Full Story

We didn't see New Zealand Oil & Gas Limited's (NZSE:NZO) stock surge when it reported robust earnings recently. We looked deeper into the numbers and found that shareholders might be concerned with some underlying weaknesses.

See our latest analysis for New Zealand Oil & Gas

Zooming In On New Zealand Oil & Gas' 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. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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".

Over the twelve months to December 2021, New Zealand Oil & Gas recorded an accrual ratio of 1.12. Statistically speaking, that's a real negative for future earnings. 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 NZ$53m, in contrast to the aforementioned profit of NZ$9.39m. We also note that New Zealand Oil & Gas' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of NZ$53m. However, as we will discuss below, we can see that the company's accrual ratio has been impacted by its tax situation. This would certainly have contributed to the weak cash conversion. One positive for New Zealand Oil & Gas shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of New Zealand Oil & Gas.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that New Zealand Oil & Gas profited from a tax benefit which contributed NZ$4.0m to profit. This is meaningful because companies usually pay tax rather than receive tax benefits. We're sure the company was pleased with its tax benefit. 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, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal. So while we think it's great to receive a tax benefit, it does tend to imply an increased risk that the statutory profit overstates the sustainable earnings power of the business.

Our Take On New Zealand Oil & Gas' Profit Performance

This year, New Zealand Oil & Gas couldn't match its profit with cashflow. On top of that, the unsustainable nature of tax benefits mean that there's a chance profit may be lower next year, certainly in the absence of strong growth. Considering all this we'd argue New Zealand Oil & Gas' 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. Be aware that New Zealand Oil & Gas is showing 2 warning signs in our investment analysis and 1 of those doesn't sit too well with us...

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. 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.