Why Incannex Healthcare's (NASDAQ:IXHL) Earnings Are Weaker Than They Seem

After announcing healthy earnings, Incannex Healthcare Inc.'s (NASDAQ:IXHL) stock rose over the last week. However, we think that shareholders should be aware of some other factors beyond the profit numbers.

Check out our latest analysis for Incannex Healthcare

A Closer Look At Incannex Healthcare'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. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. The ratio shows us how much a company's profit exceeds its FCF.

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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Incannex Healthcare has an accrual ratio of 1.76 for the year to December 2023. 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. In the last twelve months it actually had negative free cash flow, with an outflow of US$14m despite its profit of US$21.5m, mentioned above. We also note that Incannex Healthcare's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of US$14m. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

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

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Incannex Healthcare's profit was boosted by unusual items worth US$35m in the last twelve months. 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. Which is hardly surprising, given the name. Incannex Healthcare had a rather significant contribution from unusual items relative to its profit to December 2023. 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 Incannex Healthcare's Profit Performance

Summing up, Incannex Healthcare received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For all the reasons mentioned above, we think that, at a glance, Incannex Healthcare'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 Incannex Healthcare as a business, it's important to be aware of any risks it's facing. When we did our research, we found 4 warning signs for Incannex Healthcare (3 are a bit unpleasant!) that we believe deserve your full attention.

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. 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.