It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it’s not always clear whether statutory profits are a good guide, going forward. This article will consider whether Flex’s (NASDAQ:FLEX) statutory profits are a good guide to its underlying earnings.
It’s good to see that over the last twelve months Flex made a profit of US$94.5m on revenue of US$23.2b. In the last few years both its revenue and its profit have fallen, as you can see in the chart below.
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. So today we’ll look at what Flex’s cashflow and unusual items tell us about the quality of its earnings. 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 Flex’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. The ratio shows us how much a company’s profit exceeds its FCF.
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 it’s not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. To quote a 2014 paper by Lewellen and Resutek, “firms with higher accruals tend to be less profitable in the future”.
Flex has an accrual ratio of 0.45 for the year to June 2020. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn’t produce any free cash flow whatsoever. In the last twelve months it actually had negative free cash flow, with an outflow of US$1.9b despite its profit of US$94.5m, mentioned above. We also note that Flex’s free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of US$1.9b. 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
Flex’s profit suffered from unusual items, which reduced profit by US$270.7m in the last twelve months. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it’s surprising that the accrual ratio tells a different story. It’s never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. 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. Flex took a rather significant hit from unusual items in the year to June 2020. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.
Our Take On Flex’s Profit Performance
In conclusion, Flex’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 Flex’s statutory profits make it seem much weaker than it is. If you want to do dive deeper into Flex, you’d also look into what risks it is currently facing. For instance, we’ve identified 3 warning signs for Flex (2 make us uncomfortable) you should be familiar with.
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. 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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