We think Zuari Agro Chemicals’ (NSE:ZUARI) earnings are a poor guide to its profitability

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The latest publication of the results of Zuari Agro Chemicals Limited (NSE:ZUARI) disappointed investors. We dug in and found some disturbing underlying numbers.

Our analysis indicates that ZUARI is potentially undervalued!

NSEI: ZUARI Earnings and Earnings History November 19, 2022

Review of Cash Flow vs Earnings of Zuari Agro Chemicals

As finance nerds already know, the cash flow equalization ratio is a key metric for assessing how well a company’s free cash flow (FCF) matches its earnings. The strike ratio subtracts the FCF from the profit for a given period and divides the result by the average operating assets of the company over that period. This ratio tells us how much of a company’s profit is not backed by free cash flow.

This means that a negative accrual ratio is a good thing because it shows that the company is generating more free cash flow than its earnings suggest. That’s not to say we should worry about a positive accumulation ratio, but it’s worth noting where the accumulation ratio is rather high. Indeed, some academic studies have suggested that high accrual ratios tend to lead to lower earnings or less earnings growth.

For the year to September 2022, Zuari Agro Chemicals had an accrual ratio of 0.32. We can therefore deduce that its free cash flow was well below covering its statutory profit, suggesting that one should perhaps think twice before putting much weight on the latter. In the past twelve months, he had actually negative free cash flow, with an outflow of ₹755 million despite its profit of ₹9.42 billion, mentioned above. It should be noted that Zuari Agro Chemicals generated a positive FCF of ₹6.9 billion a year ago, so at least they have done so in the past. That said, there is more to the story. It can be seen that unusual elements have impacted its statutory profit, and therefore the growth ratio. A bright spot for Zuari Agro Chemicals shareholders is that its accrual ratio was significantly better last year, giving reason to believe it could revert to stronger cash conversion in the future. 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 Zuari Agro Chemicals’ balance sheet.

The impact of unusual items on earnings

Considering the strike ratio, it is not too surprising that Zuari Agro Chemicals’ profit was boosted by unusual items worth ₹11 billion in the last twelve months. While it’s always nice to have higher profits, sometimes a large contribution from unusual items dampens our enthusiasm. When we analyzed the vast majority of listed companies around the world, we found that material unusual items are often not repeated. Which is hardly surprising, given the name. We can see that the positive unusual items of Zuari Agro Chemicals were quite large compared to its profit for the year to September 2022. All things being equal, this would likely have the effect of making statutory profit a poor indicator of the underlying earning capacity.

Our view on the earnings performance of Zuari Agro Chemicals

Zuari Agro Chemicals had a weak accrual ratio, but earnings were boosted by unusual items. For the reasons mentioned above, we believe that a cursory glance at Zuari Agro Chemicals’ 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, Zuari Agro Chemicals has 3 warning signs (and 2 that shouldn’t be ignored) that we think you should know about.

Our review of Zuari Agro Chemicals has focused on some factors that can make its profits look better than they are. And, based on that, we’re somewhat skeptical. 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.

Valuation is complex, but we help make it simple.

Find out if Zuari Agro Chemicals is potentially overvalued or undervalued by viewing our full analysis, which includes fair value estimates, risks and warnings, dividends, insider trading and financial health.

See the free analysis

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.

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