Investors Shouldn't Be Too Comfortable With Allied Farmers' (NZSE:ALF) Robust Earnings

Despite posting some strong earnings, the market for Allied Farmers Limited's (NZSE:ALF) stock hasn't moved much. Our analysis suggests that this might be because shareholders have noticed some concerning underlying factors.

View our latest analysis for Allied Farmers

Examining Cashflow Against Allied Farmers' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. 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. 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.

Over the twelve months to June 2021, Allied Farmers recorded an accrual ratio of -0.16. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of NZ$3.7m, well over the NZ$2.02m it reported in profit. Notably, Allied Farmers had negative free cash flow last year, so the NZ$3.7m it produced this year was a welcome improvement. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Allied Farmers.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Allied Farmers issued 61% more new shares over the last year. That means its earnings are split among a greater number of shares. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. You can see a chart of Allied Farmers' EPS by clicking here.

A Look At The Impact Of Allied Farmers' Dilution on Its Earnings Per Share (EPS).

Allied Farmers has improved its profit over the last three years, with an annualized gain of 31% in that time. But on the other hand, earnings per share actually fell by 26% per year. And the 163% profit boost in the last year certainly seems impressive at first glance. But in comparison, EPS only increased by 63% over the same period. So you can see that the dilution has had a fairly significant impact on shareholders.

In the long term, earnings per share growth should beget share price growth. So it will certainly be a positive for shareholders if Allied Farmers 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 Allied Farmers' Profit Performance

At the end of the day, Allied Farmers 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. Based on these factors, we think it's very unlikely that Allied Farmers' statutory profits make it seem much weaker than it is. If you'd like to know more about Allied Farmers as a business, it's important to be aware of any risks it's facing. Every company has risks, and we've spotted 3 warning signs for Allied Farmers (of which 2 are a bit unpleasant!) you should know about.

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 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.
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