As a general rule, we think profitable companies are less risky than companies that lose money. 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 Nathan’s Famous’ (NASDAQ:NATH) statutory profits are a good guide to its underlying earnings.
It’s good to see that over the last twelve months Nathan’s Famous made a profit of US$12.1m on revenue of US$90.5m. The chart below shows how profit has actually increased over the last three years, even while revenue has declined.
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 Nathan’s Famous’ cashflow tells us about the quality of its earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Nathan’s Famous.
Zooming In On Nathan’s Famous’ Earnings
Many investors haven’t heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company’s profit is backed up by free cash flow (FCF) during a given period. 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’.
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. That’s because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.
Over the twelve months to June 2020, Nathan’s Famous recorded an accrual ratio of -0.35. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of US$15m during the period, dwarfing its reported profit of US$12.1m. Nathan’s Famous shareholders are no doubt pleased that free cash flow improved over the last twelve months.
Our Take On Nathan’s Famous’ Profit Performance
As we discussed above, Nathan’s Famous’ 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 Nathan’s Famous’ 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. So while earnings quality is important, it’s equally important to consider the risks facing Nathan’s Famous at this point in time. Be aware that Nathan’s Famous is showing 3 warning signs in our investment analysis and 1 of those can’t be ignored…
This note has only looked at a single factor that sheds light on the nature of Nathan’s Famous’ profit. 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.
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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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