The Strong Earnings Posted By Legimi (WSE:LEG) Are A Good Indication Of The Strength Of The Business

When companies post strong earnings, the stock generally performs well, just like Legimi S.A.'s (WSE:LEG) stock has recently. We have done some analysis, and we found several positive factors beyond the profit numbers.

Check out our latest analysis for Legimi

A Closer Look At Legimi's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. 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".

Legimi has an accrual ratio of -8.28 for the year to June 2024. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of zł12m during the period, dwarfing its reported profit of zł7.19m. Legimi shareholders are no doubt pleased that free cash flow improved over the last twelve months. Notably, the company has issued new shares, thus diluting existing shareholders and reducing 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 Legimi.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. Legimi expanded the number of shares on issue by 31% over the last year. Therefore, each share now receives a smaller portion of profit. 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 Legimi's historical EPS growth by clicking on this link.

How Is Dilution Impacting Legimi's 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. And even focusing only on the last twelve months, we don't have a meaningful growth rate because it made a loss a year ago, too. But mathematics aside, it is always good to see when a formerly unprofitable business come good (though we accept profit would have been higher if dilution had not been required). So you can see that the dilution has had a fairly significant impact on shareholders.

In the long term, if Legimi's earnings per share can increase, then the share price should too. 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.

Our Take On Legimi's Profit Performance

In conclusion, Legimi has a strong cashflow relative to earnings, which indicates good quality earnings, but the dilution means its earnings per share are dropping faster than its profit. Based on these factors, we think that Legimi's profits are a reasonably conservative guide to its underlying profitability. If you want to do dive deeper into Legimi, you'd also look into what risks it is currently facing. In terms of investment risks, we've identified 3 warning signs with Legimi, and understanding these should be part of your investment process.

Our examination of Legimi has focussed on certain factors that can make its earnings look better than they are. 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 with significant insider holdings 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.