As a general rule, we think profitable companies are less risky than companies that lose money. 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. Today we’ll focus on whether this year’s statutory profits are a good guide to understanding Divi’s Laboratories (NSE:DIVISLAB).
We like the fact that Divi’s Laboratories made a profit of ₹13.8b on its revenue of ₹53.9b, in the last year. Happily, it has grown both its profit and revenue over the last three years, as you can see in the chart below.
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. As a result, we think it’s well worth considering what Divi’s Laboratories’s cashflow (when compared to its earnings) can tell us about the nature of its statutory profit. That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.
Examining Cashflow Against Divi’s Laboratories’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 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.
Over the twelve months to March 2020, Divi’s Laboratories recorded an accrual ratio of 0.23. Unfortunately, that means its free cash flow fell significantly short of its reported profits. In fact, it had free cash flow of ₹327m in the last year, which was a lot less than its statutory profit of ₹13.8b. Divi’s Laboratories shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months.
Our Take On Divi’s Laboratories’s Profit Performance
Divi’s Laboratories’s accrual ratio for the last twelve months signifies cash conversion is less than ideal, which is a negative when it comes to our view of its earnings. Therefore, it seems possible to us that Divi’s Laboratories’s true underlying earnings power is actually less than its statutory profit. Nonetheless, it’s still worth noting that its earnings per share have grown at 30% over the last three years. Of course, we’ve only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. In light of this, if you’d like to do more analysis on the company, it’s vital to be informed of the risks involved. For example, we’ve found that Divi’s Laboratories has 2 warning signs (1 is concerning!) that deserve your attention before going any further with your analysis.
Today we’ve zoomed in on a single data point to better understand the nature of Divi’s Laboratories’s profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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. 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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