Investors were disappointed with Incannex Healthcare Inc.'s (NASDAQ:IXHL) recent earnings release. We did some digging and found some underlying numbers that are worrying.

Examining Cashflow Against Incannex Healthcare'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to March 2024, Incannex Healthcare had an accrual ratio of 1.78. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of US$19.6m, a look at free cash flow indicates it actually burnt through US$15m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of US$15m, this year, indicates high risk. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Incannex Healthcare.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by US$35m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And, after all, that's exactly what the accounting terminology implies. We can see that Incannex Healthcare's positive unusual items were quite significant relative to its profit in the year to March 2024. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Incannex Healthcare's Profit Performance

Summing up, Incannex Healthcare received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. On reflection, the above-mentioned factors give us the strong impression that Incannex Healthcare'sunderlying earnings power is not as good as it might seem, based on the statutory profit numbers. If you'd like to know more about Incannex Healthcare as a business, it's important to be aware of any risks it's facing. Our analysis shows 4 warning signs for Incannex Healthcare (3 don't sit too well with us!) and we strongly recommend you look at these before investing.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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 with significant insider holdings to be useful.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.