We Don’t Think Redan's (WSE:RDN) Earnings Should Make Shareholders Too Comfortable

Shareholders were pleased with the recent earnings report from Redan S.A. (WSE:RDN). However, we think that investors should be cautious when interpreting the profit numbers.

View our latest analysis for Redan

Examining Cashflow Against Redan's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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'.

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. 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 2020, Redan had an accrual ratio of 2.21. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of zł22.2m, a look at free cash flow indicates it actually burnt through zł1.5m in the last year. We saw that FCF was zł26m a year ago though, so Redan has at least been able to generate positive FCF in the past. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio. One positive for Redan 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. As a result, some shareholders may be looking for stronger cash conversion in the current year.

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

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by zł28m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's as you'd expect, given these boosts are described as 'unusual'. Redan had a rather significant contribution from unusual items relative to its profit to December 2020. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Redan's Profit Performance

Summing up, Redan received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. On reflection, the above-mentioned factors give us the strong impression that Redan'sunderlying earnings power is not as good as it might seem, based on the statutory profit numbers. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. To help with this, we've discovered 4 warning signs (3 are significant!) that you ought to be aware of before buying any shares in Redan.

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 is always more to discover if you are capable of focussing your mind on minutiae. 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. 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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