Strong earnings were not enough to satisfy Imagicaaworld Entertainment Limited (NSE:IMAGICAA) shareholders for the past week. We did some digging and found some underlying numbers that are worrying.
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Examination of cash flow versus Imagicaaworld Entertainment revenue
In high finance, the metric used to measure how well a company is converting reported earnings into free cash flow (FCF) is the accrual rate (from cash flow). Put simply, this ratio subtracts FCF from net income and divides that number by the company’s average operating assets during that period. This ratio tells us how much of a company’s earnings aren’t covered by free cash flow.
That means a negative accrual ratio is a good thing, because it shows the company is bringing in more free cash flow than its earnings suggest. That’s not to say that we should worry about a positive cut rate, but it’s worth noting where the cut rate is quite high. To quote a 2014 paper by Lewellen and Resutek, “Firms with higher reserves tend to be less profitable going forward.”
Imagicaaworld Entertainment has a reserve ratio of 0.72 for the year ended September 2022. That means it didn’t generate nearly enough free cash flow to match its profit. Statistically, this is a real minus for future earnings. In fact, it had free cash flow of ₹279 million last year, which was much less than the statutory profit of ₹4.20 billion. However, we note that Imagicaaworld Entertainment has grown its free cash flow over the past year. However, that is not the end of the story. We also need to consider the impact of unusual items on the statutory profit (and therefore the accrual rate) as well as the impact of the company’s issuance of new shares. The good news for shareholders is that Imagicaaworld Entertainment’s reserving ratio was much better last year, so this year’s poor numbers may simply be due to a short-term discrepancy between earnings and FCF. As a result, some shareholders may be looking for more cash conversion in the current year.
Note: We always advise investors to review balance sheet strength. Click here for our Imagicaaworld Entertainment balance sheet analysis.
A key aspect of assessing earnings quality is how much a company dilutes shareholders. In fact, Imagicaaworld Entertainment has increased the number of shares outstanding by 367% over the last twelve months by issuing new shares. As a result, the net profit is now split across a larger number of shares. Celebrating net income while ignoring thinning is like being happy because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now being cut into many more slices. You can see a chart of Imagicaaworld Entertainment’s EPS by clicking here.
A look at the impact of Imagicaaworld Entertainment’s dilution on earnings per share (EPS)
Imagicaaworld Entertainment lost money three years ago. And even if we only focus on the last 12 months, we don’t have a meaningful growth rate because it was also making a loss a year ago. What we do know is that while it’s great to see earnings over the trailing 12 months, those earnings per share would have been better had the company not had to issue shares. As such, one can observe that dilution has a fairly profound impact on shareholder returns.
If Imagicaaworld Entertainment’s earnings per share can grow over time, it dramatically improves the chances of the stock price moving in the same direction. However, if earnings rise while earnings per share remain flat (or even fall), shareholders may not see much benefit. For this reason, it could be said that EPS is more important than net income over the long term, assuming the goal is to assess whether a company’s stock price could rise.
The Impact of Unusual Items on Profit
Given the response rate, it’s not too surprising that Imagicaaworld Entertainment’s profit has been boosted by £4.9bn worth of unusual items over the last 12 months. While it’s always nice to have a higher profit, a large contribution of unusual items sometimes dampens our enthusiasm. When we analyzed the vast majority of publicly traded companies worldwide, we found that significant unusual elements are often not repeated. And that, after all, is exactly what the accounting terminology implies. We can see that Imagicaaworld Entertainment’s positive unusual items were quite significant relative to its earnings for the year ended September 2022. All else being equal, this would likely result in statutory profit being a poor indicator of underlying earning power.
Our assessment of Imagicaaworld Entertainment’s earnings development
Imagicaaworld Entertainment hasn’t underpinned its profits with free cash flow, but that’s not too surprising given that unusual items inflated profits. The dilution means earnings are weaker from a per-share perspective. For all of the above reasons, we believe that Imagicaaworld Entertainment’s legal earnings could, at first glance, be considered low quality as they are likely to give investors an overly positive impression of the company. If you want to delve deeper into Imagicaaworld Entertainment, you should also look into the risks it currently faces. To help with that, we discovered 4 warning signs (3 are worrying!) that you should consider before buying Imagicaaworld Entertainment stock.
In this article, we’ve looked at a number of factors that can affect the usefulness of winning numbers, and we’ve become cautious. But there’s always more to discover if you’re able to focus on the little things. Some people think that a high return on equity is a good sign of a quality company. While it may take a little research on your behalf, you can find this free Collection of companies with high return on equity or this list of stocks that insiders buy to be useful.
The assessment is complex, but we help to simplify it.
find out if Imagicaaworld Entertainment may be over or under priced by reviewing our comprehensive analysis which includes the following Fair Value Estimates, Risks and Warnings, Dividends, Insider Trading and Financial Health.
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This Simply Wall St article is of a general nature. We provide comments based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended as financial advice. It is not a recommendation to buy or sell any stock and does not take into account your goals or financial situation. Our goal is to offer you long-term focused analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any of the stocks mentioned.