We have not seen Capricorn Metals Ltd (ASX:CMM) Stocks surged when they recently reported strong earnings. We decided to deepen our analysis and we believe that investors might be concerned about several worrying factors that we have discovered.

See our latest analysis for Capricorn Metals

Focus on Capricorn Metals earnings

In high finance, the key ratio used to measure a company’s ability to convert reported earnings into free cash flow (FCF) is the exercise ratio (cash). 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. This ratio tells us how much of a company’s profit is not backed by free cash flow.

Therefore, it is 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 a accrual ratio greater than zero is of little concern, we believe it is worth noting when a company has a relatively high accrual ratio. Notably, there is academic evidence that suggests a high exercise ratio is a bad sign for short-term profits, generally speaking.

Capricorn Metals has an accrual ratio of 0.65 for the year to December 2021. Statistically speaking, this is a real negative for future earnings. And indeed, during the period, the company produced no free cash flow. Although he reported a profit of A$49.4m, a look at free cash flow shows he actually spent A$69m in the past year. We also note that Capricorn Metals’ free cash flow was also negative last year, so we could understand if shareholders were bothered by its A$69 million outflow. Unfortunately for shareholders, the company also issued new shares, diluting their share of future earnings.

This might make you wonder what analysts predict in terms of future profitability. Luckily, you can click here to see an interactive chart outlining future profitability, based on their estimates.

To understand the value of a company’s earnings growth, it is imperative to consider any dilution of shareholder interests. Capricorn Metals has increased the number of shares issued by 8.0% over the past year. This means that its profits are distributed among a larger number of shares. Talking about net profit, without noticing earnings per share, is being distracted by the big numbers while ignoring the small numbers that speak to per share assess. You can see a graphic of the Capricorn Metals EPS by clicking here.

What is the impact of dilution on Capricorn Metals earnings per share? (EPS)

Capricorn Metals 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). Therefore, dilution has a significant influence on shareholder returns.

In the long term, if the profits of Capricorn Metals 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.

Our view on Capricorn Metals earnings performance

In conclusion, Capricorn Metals has a low cash flow to earnings ratio, which indicates lower quality earnings, and the dilution means that shareholders now own a smaller proportion of the company (assuming they retain the same number of actions). For the reasons mentioned above, we believe that a cursory glance at Capricorn Metals’ statutory earnings might make it look better than it actually is on an underlying level. In light of this, if you want to do more analysis on the company, it is essential to be aware of the risks involved. For example, we have identified 2 warning signs for Capricorn Metals (1 makes us a little uneasy) that you should know.

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’s always more to discover if you’re able to focus on the details. Some people consider a high return on equity to be a good sign of a quality company. Although it might take a bit of research on your behalf, you might find this free collection of companies offering a high return on equity, or this list of stocks that insiders buy to be useful.

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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.