Are Lexicon Pharmaceuticals’s (NASDAQ:LXRX) Statutory Earnings A Good Guide To Its Underlying Profitability?

As a general rule, we think profitable companies are less risky than companies that lose money. That said, the current statutory profit is not always a good guide to a company’s underlying profitability. In this article, we’ll look at how useful this year’s statutory profit is, when analysing Lexicon Pharmaceuticals (NASDAQ:LXRX).

While Lexicon Pharmaceuticals was able to generate revenue of US$330.4m in the last twelve months, we think its profit result of US$164.5m was more important. The chart below shows that revenue has improved over the last three years, and, even better, the company has moved from unprofitable to profitable.

Check out our latest analysis for Lexicon Pharmaceuticals

NasdaqGS:LXRX Income Statement, January 7th 2020
NasdaqGS:LXRX Income Statement, January 7th 2020

Not all profits are equal, and we can learn more about the nature of a company’s past profitability by diving deeper into the financial statements. As a result, today we’re going to take a closer look at Lexicon Pharmaceuticals’s cashflow, and unusual items, with a view to understanding what these might tell us about its statutory profit. That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

Zooming In On Lexicon Pharmaceuticals’s Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). The accrual 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 time. This ratio tells us how much of a company’s profit is not backed by free cashflow.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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.

Over the twelve months to September 2019, Lexicon Pharmaceuticals recorded an accrual ratio of 0.76. Ergo, its free cash flow is significantly weaker than its profit. As a general rule, that bodes poorly for future profitability. Indeed, in the last twelve months it reported free cash flow of US$111m, which is significantly less than its profit of US$164.5m. Notably, Lexicon Pharmaceuticals had negative free cash flow last year, so the US$111m it produced this year was a welcome improvement.

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.

The Impact Of Unusual Items On Profit

Unfortunately (in the short term) Lexicon Pharmaceuticals saw its profit reduced by unusual items worth US$29m. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it’s not great to see in combination with an uninspiring accrual ratio. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that’s exactly what the accounting terminology implies. If Lexicon Pharmaceuticals doesn’t see those unusual expenses repeat, then all else being equal we’d expect its profit to increase over the coming year.

Our Take On Lexicon Pharmaceuticals’s Profit Performance

In conclusion, Lexicon Pharmaceuticals’s accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Based on these factors, we think it’s very unlikely that Lexicon Pharmaceuticals’s statutory profits make it seem much weaker than it is. While it’s really important to consider how well a company’s statutory earnings represent its true earnings power, it’s also worth taking a look at what analysts are forecasting for the future. So feel free to check out our free graph representing analyst forecasts.

In this article we’ve looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. But there are plenty of other ways to inform your opinion of a company. 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

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