As a general rule, we think profitable companies are less risky than companies that lose money. 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. In this article, we’ll look at how useful this year’s statutory profit is, when analysing Ligand Pharmaceuticals (NASDAQ:LGND).
We like the fact that Ligand Pharmaceuticals made a profit of US$629.3m on its revenue of US$120.3m, in the last year. The good news is that the company managed to grow its revenue over the last three years, and also move from loss-making to profitable.
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 Ligand Pharmaceuticals’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.
Examining Cashflow Against Ligand 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). To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the 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. 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”.
Over the twelve months to December 2019, Ligand Pharmaceuticals recorded an accrual ratio of -0.40. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. In fact, it had free cash flow of US$781m in the last year, which was a lot more than its statutory profit of US$629.3m. Ligand Pharmaceuticals’s free cash flow improved over the last year, which is generally good to see. However, that’s not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.
How Do Unusual Items Influence Profit?
While the accrual ratio might bode well, we also note that Ligand Pharmaceuticals’s profit was boosted by unusual items worth US$810m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it’s very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. We can see that Ligand Pharmaceuticals’s positive unusual items were quite significant relative to its profit in the year to December 2019. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.
Our Take On Ligand Pharmaceuticals’s Profit Performance
Ligand Pharmaceuticals’s profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Given the contrasting considerations, we’re don’t have a strong view as to whether Ligand Pharmaceuticals’s profits are an apt reflection of its underlying potential for profit. If you’d like to know more about Ligand Pharmaceuticals as a business, it’s important to be aware of any risks it’s facing. For instance, we’ve identified 4 warning signs for Ligand Pharmaceuticals (2 shouldn’t be ignored) 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 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. 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 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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