Elemental Asia's (WSE:EMA) Promising Earnings May Rest On Soft Foundations

Despite posting some strong earnings, the market for Elemental Asia S.A.'s (WSE:EMA) stock hasn't moved much. Our analysis suggests that shareholders have noticed something concerning in the numbers.

Check out our latest analysis for Elemental Asia

Examining Cashflow Against Elemental Asia'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). The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. 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 March 2022, Elemental Asia recorded an accrual ratio of 2.31. 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 zł7.24m, a look at free cash flow indicates it actually burnt through zł24m in the last year. We saw that FCF was zł1.4m a year ago though, so Elemental Asia has at least been able to generate positive FCF in the past.

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

Our Take On Elemental Asia's Profit Performance

As we have made quite clear, we're a bit worried that Elemental Asia didn't back up the last year's profit with free cashflow. For this reason, we think that Elemental Asia's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But at least holders can take some solace from the 52% EPS growth in the last year. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. So while earnings quality is important, it's equally important to consider the risks facing Elemental Asia at this point in time. Every company has risks, and we've spotted 3 warning signs for Elemental Asia (of which 1 shouldn't be ignored!) you should know about.

This note has only looked at a single factor that sheds light on the nature of Elemental Asia's profit. 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.