Shareholders Shouldn’t Be Too Comfortable With Radius Residential Care's (NZSE:RAD) Strong Earnings

Even though Radius Residential Care Limited (NZSE:RAD) posted strong earnings recently, the stock hasn't reacted in a large way. We think that investors might be worried about the foundations the earnings are built on.

View our latest analysis for Radius Residential Care

A Closer Look At Radius Residential Care'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. 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.

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 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. 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 March 2022, Radius Residential Care had an accrual ratio of 0.43. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of NZ$2.67m, a look at free cash flow indicates it actually burnt through NZ$29m in the last year. It's worth noting that Radius Residential Care generated positive FCF of NZ$10m a year ago, so at least they've done it in the past. However, that's not the end of the story. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively. One positive for Radius Residential Care 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 Radius Residential Care.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. Radius Residential Care expanded the number of shares on issue by 53% 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 Radius Residential Care's historical EPS growth by clicking on this link.

A Look At The Impact Of Radius Residential Care'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. On the bright side, in the last twelve months it grew profit by 57%. On the other hand, earnings per share are only up 16% 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 Radius Residential Care can grow EPS persistently. 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.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Radius Residential Care's profit was boosted by unusual items worth NZ$2.5m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And that's as you'd expect, given these boosts are described as 'unusual'. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Radius Residential Care's Profit Performance

In conclusion, Radius Residential Care's weak accrual ratio suggested its statutory earnings have been inflated by the unusual items. The dilution means the results are weaker when viewed from a per-share perspective. For all the reasons mentioned above, we think that, at a glance, Radius Residential Care's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. If you want to do dive deeper into Radius Residential Care, you'd also look into what risks it is currently facing. To help with this, we've discovered 4 warning signs (3 are a bit unpleasant!) that you ought to be aware of before buying any shares in Radius Residential Care.

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.