Here's Why We Don't Think Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna's (WSE:ZRE) Statutory Earnings Reflect Its Underlying Earnings Potential

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. Today we'll focus on whether this year's statutory profits are a good guide to understanding Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna (WSE:ZRE).

We like the fact that Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna made a profit of zł6.69m on its revenue of zł25.6m, in the last year. The good news is that the company managed to grow its revenue over the last three years, and also move from loss-making to profitable.

Check out our latest analysis for Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. So this article aims to better understand Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna's underlying earnings power by taking a look at how dilution, and unusual items are impacting it, and considering how well those paper profits are being converted into cash flow. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna.

A Closer Look At Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna'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. 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. 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 September 2020, Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna recorded an accrual ratio of 1.09. 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. Over the last year it actually had negative free cash flow of zł1.5m, in contrast to the aforementioned profit of zł6.69m. It's worth noting that Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna generated positive FCF of zł5.4m 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. The good news for shareholders is that Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna expanded the number of shares on issue by 9.8% over the last year. Therefore, each share now receives a smaller portion of profit. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. Check out Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna's historical EPS growth by clicking on this link.

A Look At The Impact Of Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna's Dilution on Its Earnings Per Share (EPS).

Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna was losing money three years ago. On the bright side, in the last twelve months it grew profit by 70%. But EPS was less impressive, up only 100% in that time. So you can see that the dilution has had a bit of an impact on shareholders. Therefore, the dilution is having a noteworthy influence on shareholder returns. And so, you can see quite clearly that dilution is influencing shareholder earnings.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So it will certainly be a positive for shareholders if Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna 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.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna's profit was boosted by unusual items worth zł7.4m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna had a rather significant contribution from unusual items relative to its profit to September 2020. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna's Profit Performance

In conclusion, Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna's weak accrual ratio suggested its statutory earnings have been inflated by the unusual items. Meanwhile, the new shares issued mean that shareholders now own less of the company, unless they tipped in more cash themselves. For all the reasons mentioned above, we think that, at a glance, Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna'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'd like to know more about Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna as a business, it's important to be aware of any risks it's facing. To help with this, we've discovered 4 warning signs (3 can't be ignored!) that you ought to be aware of before buying any shares in Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna.

Our examination of Zaklad Budowy Maszyn ZREMB - Chojnice Spolka Akcyjna has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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. 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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