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. Today we’ll focus on whether this year’s statutory profits are a good guide to understanding Big 5 Sporting Goods (NASDAQ:BGFV).
We like the fact that Big 5 Sporting Goods made a profit of US$3.00m on its revenue of US$999.5m, in the last year.
Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. Therefore, we think it’s worth taking a closer look at Big 5 Sporting Goods’s cashflow, as well as examining the impact that unusual items have had on its reported profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Big 5 Sporting Goods.
Zooming In On Big 5 Sporting Goods’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). 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’.
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. While having an accrual ratio above zero is of little concern, we do think it’s worth noting when a company has a relatively high accrual ratio. To quote a 2014 paper by Lewellen and Resutek, “firms with higher accruals tend to be less profitable in the future”.
Big 5 Sporting Goods has an accrual ratio of -0.12 for the year to September 2019. Therefore, its statutory earnings were quite a lot less than its free cashflow. In fact, it had free cash flow of US$33m in the last year, which was a lot more than its statutory profit of US$3.00m. Notably, Big 5 Sporting Goods had negative free cash flow last year, so the US$33m it produced this year was a welcome improvement. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.
How Do Unusual Items Influence Profit?
Big 5 Sporting Goods’s profit was reduced by unusual items worth US$848k in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you’d expect to see where a company has a non-cash charge reducing paper profits. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that’s hardly a surprise given these line items are considered unusual. If Big 5 Sporting Goods 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 Big 5 Sporting Goods’s Profit Performance
Considering both Big 5 Sporting Goods’s accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company’s underlying earnings power. Looking at all these factors, we’d say that Big 5 Sporting Goods’s underlying earnings power is at least as good as the statutory numbers would make it seem. While it’s very important to consider the profit and loss statement, you can also learn a lot about a company by looking at its balance sheet. You can seeour latest analysis on Big 5 Sporting Goods’s balance sheet health here.
Our examination of Big 5 Sporting Goods has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. But there are plenty of other ways to inform your opinion of a company. Some people consider a high return on equity to be a good sign of a quality business. 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 that insiders are buying to be useful.
If you spot an error that warrants correction, please contact the editor at email@example.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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