Here's Why We Don't Think Al Kathiri Holding's (TADAWUL:3008) Statutory Earnings Reflect Its Underlying Earnings Potential

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. This article will consider whether Al Kathiri Holding's (TADAWUL:3008) statutory profits are a good guide to its underlying earnings.

We like the fact that Al Kathiri Holding made a profit of ر.س9.27m on its revenue of ر.س93.7m, in the last year. In the chart below, you can see that its profit and revenue have both grown over the last three years, although its profit has slipped in the last twelve months.

View our latest analysis for Al Kathiri Holding

Not all profits are equal, and we can learn more about the nature of a company's past profitability by diving deeper into the financial statements. So today we'll look at what Al Kathiri Holding's cashflow tells us about its earnings, as well as examining how issuing shares is impacting shareholder value. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Al Kathiri Holding.

Zooming In On Al Kathiri Holding'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. 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. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to September 2020, Al Kathiri Holding had an accrual ratio of 0.28. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Even though it reported a profit of ر.س9.27m, a look at free cash flow indicates it actually burnt through ر.س17m in the last year. We saw that FCF was ر.س2.3m a year ago though, so Al Kathiri Holding has at least been able to generate positive FCF in the past. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. In fact, Al Kathiri Holding increased the number of shares on issue by 100% over the last twelve months by issuing new shares. Therefore, each share now receives a smaller portion of profit. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. Check out Al Kathiri Holding's historical EPS growth by clicking on this link.

How Is Dilution Impacting Al Kathiri Holding's Earnings Per Share? (EPS)

Al Kathiri Holding has improved its profit over the last three years, with an annualized gain of 7.4% in that time. Net income was down 29% over the last twelve months. But the EPS result was even worth, with the company recording a decline of 36%. Therefore, one can observe that the dilution is having a fairly profound effect on shareholder returns.

If Al Kathiri Holding's EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

Our Take On Al Kathiri Holding's Profit Performance

As it turns out, Al Kathiri Holding couldn't match its profit with cashflow and its dilution means that shareholders own less of the company than the did before (unless they bought more shares). For the reasons mentioned above, we think that a perfunctory glance at Al Kathiri Holding's statutory profits might make it look better than it really is on an underlying level. So while earnings quality is important, it's equally important to consider the risks facing Al Kathiri Holding at this point in time. Every company has risks, and we've spotted 5 warning signs for Al Kathiri Holding (of which 2 are significant!) you should know about.

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. 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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