Karoon Energy (ASX: KAR) profits appear to have quality issues

The share price did not jump after Karoon Energy Ltd (ASX: KAR) posted decent gains last week. We believe there are some underlying factors of concern to investors.

Check out our latest analysis for Karoon Energy

ASX: KAR Earnings and Revenue History September 26, 2021

Focus on the benefits of Karoon Energy

Many investors have not heard of the cash flow adjustment ratio, but it’s actually a useful measure of the extent to which a company’s profit is supported by Free Cash Flow (FCF) over a given period. Simply put, this ratio subtracts FCF from net income and divides that number by the company’s average operating assets over that period. You could think of the accumulation ratio from cash flow as the “non FCF profit ratio”.

Therefore, a negative accumulation ratio is positive for the company and a positive accumulation ratio is negative. This is not to say that we should be worried about a positive accumulation ratio, but it should be noted where the accumulation ratio is rather high. To quote a 2014 article by Lewellen and Resutek, “Firms with higher totals tend to be less profitable in the future.”

Karoon Energy has an accumulation ratio of 0.95 for the year through June 2021. Generally speaking, this bodes poorly for future profitability. And indeed, during the period, the company produced no free cash flow. Even though it reported a profit of $ 4.38 million, a free cash flow review indicates that it actually burned $ 143 million in the past year. Coming out of negative free cash flow last year, we imagine some shareholders might wonder if its consumption of US $ 143 million this year indicates high risk. That said, it appears that a recent tax benefit and some unusual items impacted its bottom line (and its accrual ratio).

This might make you wonder what analysts are predicting in terms of future profitability. Fortunately, you can click here to see an interactive graph depicting future profitability, based on their estimates.

The impact of unusual items on profit

Karoon Energy’s earnings suffered from unusual items, which reduced earnings by US $ 16 million over the past twelve months. In the event that this was a non-cash load, it would have been easier to have a high cash conversion, so it’s surprising that the build-up ratio tells a different story. It’s never great to see unusual items costing the business a profit, but on the upside, things might get better sooner rather than later. We have looked at thousands of listed companies and found that unusual items are very often unique in nature. And, after all, that’s exactly what accounting terminology implies. Karoon Energy was hit quite a bit by unusual items during the year up to June 2021. All other things being equal, this would likely have the effect of making statutory profit appear worse than its underlying profit power.

An unusual tax situation

Moving on from the regularization ratio, let us note that Karoon Energy benefited from a tax advantage which contributed US $ 32 million to the result. It’s always a bit remarkable when a business is paid by the IRS, rather than paying the IRS. Sure, At first glance it’s great to receive a tax benefit. And since he has already lost money, it might just indicate the realization of past tax losses. However, our data indicates that tax benefits may temporarily increase statutory profit in the year it is recognized, but profit may then decline. In the probable event that the tax advantage does not recur, we would expect its statutory profit levels to decline, at least in the absence of strong growth. So while we think it’s great to have a tax benefit, it usually involves an increased risk that statutory profit overestimates the company’s sustainable earning capacity.

Our perspective on Karoon Energy earnings performance

In summary, the unusual evidence from Karoon Energy suggests that its statutory profits have been temporarily depressed, while its tax advantage has the opposite effect, and its accrual ratio indicates a lack of free cash flow relative to profit. Taking all this into account, we would say that Karoon Energy’s earnings probably give an overly generous impression of its sustainable level of profitability. So while the quality of the earnings is important, it is just as important to consider the risks that Karoon Energy is currently facing. To help you, we have discovered 2 warning signs (1 is a little worrying!) Which you should know before buying Karoon Energy shares.

Our review of Karoon Energy focused on some factors that can make its income better than it is. And, on that basis, we are somewhat skeptical. But there is always more to be discovered if you are able to focus your mind on the smallest details. Some people consider a high return on equity to be a good sign of a quality business. So you might want to see this free a set of companies with a high return on equity, or that 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 using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.
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