Shareholders Can Be Confident That Innodata's (NASDAQ:INOD) Earnings Are High Quality

Even though Innodata Inc.'s (NASDAQ:INOD) recent earnings release was robust, the market didn't seem to notice. Investors are probably missing some underlying factors which are encouraging for the future of the company.

See our latest analysis for Innodata

A Closer Look At Innodata'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). 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.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Innodata has an accrual ratio of -0.29 for the year to March 2021. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of US$4.3m, well over the US$1.31m it reported in profit. Innodata shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that, there is more to consider. 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.

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

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. Innodata expanded the number of shares on issue by 7.5% 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 Innodata's historical EPS growth by clicking on this link.

How Is Dilution Impacting Innodata's Earnings Per Share? (EPS)

Three years ago, Innodata lost money. Zooming in to the last year, we still can't talk about growth rates coherently, since it made a loss last year. What we do know is that while it's great to see a profit over the last twelve months, that profit would have been better, on a per share basis, if the company hadn't needed to issue shares. Therefore, the dilution is having a noteworthy influence on shareholder returns.

If Innodata's EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. 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.

The Impact Of Unusual Items On Profit

Innodata's profit was reduced by unusual items worth US$1.1m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. Innodata took a rather significant hit from unusual items in the year to March 2021. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.

Our Take On Innodata's Profit Performance

Summing up, Innodata's accrual ratio and its unusual items suggest that its statutory earnings were temporarily depressed (and could bounce back), while the dilution is a negative for shareholders. Based on these factors, we think Innodata's earnings potential is at least as good as it seems, and maybe even better! So while earnings quality is important, it's equally important to consider the risks facing Innodata at this point in time. Case in point: We've spotted 4 warning signs for Innodata you should be aware of.

Our examination of Innodata has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. But there are plenty of other ways to inform your opinion of a company. Some people consider a high return on equity to be a good sign of a quality business. 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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