Pro Medicus's (ASX:PME) Earnings Are Growing But Is There More To The Story?

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. Today we'll focus on whether this year's statutory profits are a good guide to understanding Pro Medicus (ASX:PME).

It's good to see that over the last twelve months Pro Medicus made a profit of AU$22.1m on revenue of AU$54.1m. One positive is that it has grown both its profit and its revenue, over the last few years.

Check out our latest analysis for Pro Medicus

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. Today, we'll discuss Pro Medicus' free cashflow relative to its earnings, and consider what that tells us about the company. 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.

A Closer Look At Pro Medicus' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Pro Medicus has an accrual ratio of -0.32 for the year to December 2019. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of AU$27m during the period, dwarfing its reported profit of AU$22.1m. Pro Medicus shareholders are no doubt pleased that free cash flow improved over the last twelve months.

Our Take On Pro Medicus' Profit Performance

As we discussed above, Pro Medicus' accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Based on this observation, we consider it possible that Pro Medicus' statutory profit actually understates its earnings potential! And on top of that, its earnings per share have grown at an extremely impressive rate over the last three years. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. In terms of investment risks, we've identified 1 warning sign with Pro Medicus, and understanding this should be part of your investment process.

Today we've zoomed in on a single data point to better understand the nature of Pro Medicus' profit. 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. 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.

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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. 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.
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