Although Limited ISMT (NSE: ISMTLTD) posted strong earnings recently, the stock failed to react significantly. We took a deeper look at the numbers and found that shareholders might be concerned about some underlying weaknesses.
Check out our latest analysis for ISMT
A closer look at the benefits of ISMT
A key financial ratio used to measure a company’s ability to convert earnings into free cash flow (FCF) is the exercise ratio. To get the strike ratio, we first subtract FCF from earnings for a period and then divide that number by the average operating assets for the period. You can think of the cash flow equalization ratio as the “non-FCF profit ratio”.
Therefore, a negative accrual ratio is positive for the company and a positive accrual ratio is negative. While it’s fine to have a positive accrual ratio, indicating some level of non-monetary benefits, a high accrual ratio is arguably a bad thing, as it indicates that the earnings on paper do not match the cash flow. To quote a 2014 paper by Lewellen and Resutek, “Companies with higher accrued liabilities tend to be less profitable in the future.”
Over the twelve months to March 2022, ISMT recorded a accrual ratio of 2.14. That means it didn’t generate enough free cash flow to match its earnings. Statistically speaking, this is a real negative for future profits. Indeed, in the last twelve months, it recorded a free cash flow of ₹945 million, which is significantly lower than its profit of ₹23.7 billion. At this point, we have to mention that ISMT has managed to increase its free cash flow over the last twelve months. That said, there is more to consider. We can examine the impact of unusual income statement items on its accrual ratio, as well as the negative impact of dilution on shareholders. The good news for shareholders is that ISMT’s settlement ratio was much better last year, so this year’s poor reading could simply be a case of a short-term mismatch between earnings and FCF. Shareholders should look for an improvement in cash flow over current year earnings, if that is indeed the case.
To note: we always recommend that investors check the strength of the balance sheet. Click here to access our analysis of ISMT’s balance sheet.
To understand the value of a company’s earnings growth, it is imperative to consider any dilution of shareholder interests. ISMT has increased the number of shares issued by 157% over the past year. This means that its profits are distributed among a larger number of shares. Celebrating net income while ignoring dilution is like rejoicing that you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into multiple slices. Learn about ISMT’s historic EPS growth by clicking this link.
A look at the impact of ISMT’s dilution on its earnings per share (EPS).
ISMT was losing money three years ago. And even focusing only on the last twelve months, we don’t have a significant growth rate, because also a year ago there was a loss. But math aside, it’s always good to see when a once unprofitable business turns good (although we accept that the profit would have been higher had the dilution not been necessary). And so, we can quite clearly see that dilution has a fairly significant impact on shareholders.
In the long term, if the benefits of ISMT per share may rise, the stock price should also rise. However, if its earnings increase while its earnings per share remain stable (or even decline), shareholders might not see much benefit. For this reason, one could argue that EPS is more important than long-term net income, assuming the goal is to gauge whether a company’s stock price can rise.
How do unusual items affect profits?
Considering the strike ratio, it is not too surprising that ISMT’s profit was boosted by unusual items worth ₹25 billion in the last twelve months. While we like to see increases in earnings, we tend to be a bit more cautious when unusual items have made a big contribution. When we analyzed the vast majority of listed companies around the world, we found that material unusual items are often not repeated. And that’s as you’d expect, given that these boosts are described as “unusual.” ISMT had a fairly large contribution of unusual items to its earnings through March 2022. All other things being equal, this would likely make statutory earnings a poor indicator of underlying earning power.
Our view on ISMT’s earnings performance
ISMT didn’t support its earnings with free cash flow, but that’s not too surprising given that earnings were inflated by unusual items. Meanwhile, new shares issued mean that shareholders now own less of the company, unless they themselves contribute more cash. On reflection, the factors mentioned above give us the strong impression that ISMT’s underlying earning power is not as good as it looks, based on the statutory earnings numbers. With this in mind, we would not consider investing in a stock unless we have a thorough understanding of the risks. For example, we found 2 warning signs that you should scan your eye to get a better picture of the ISMT.
In this article, we’ve looked at a number of factors that can detract from the usefulness of profit numbers, and came out cautious. But there are many other ways to inform your opinion about a company. For example, many people view a high return on equity as an indication of a favorable trading economy, while others like to “follow the money” and look for stocks that insiders are buying. So you might want to see this free collection of companies offering a high return on equity, or this list of stocks that insiders buy.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.