Why Downer EDI's (ASX:DOW) Earnings Are Better Than They Seem

Shareholders appeared to be happy with Downer EDI Limited's (ASX:DOW) solid earnings report last week. According to our analysis of the report, the strong headline profit numbers are supported by strong earnings fundamentals.

See our latest analysis for Downer EDI

A Closer Look At Downer EDI's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to June 2024, Downer EDI recorded an accrual ratio of -0.12. Therefore, its statutory earnings were quite a lot less than its free cashflow. In fact, it had free cash flow of AU$398m in the last year, which was a lot more than its statutory profit of AU$56.1m. Downer EDI shareholders are no doubt pleased that free cash flow improved over the last twelve months. 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.

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.

How Do Unusual Items Influence Profit?

Downer EDI's profit was reduced by unusual items worth AU$80m 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. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect Downer EDI to produce a higher profit next year, all else being equal.

Our Take On Downer EDI's Profit Performance

Considering both Downer EDI'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 Downer EDI's underlying earnings power is at least as good as the statutory numbers would make it seem. If you'd like to know more about Downer EDI as a business, it's important to be aware of any risks it's facing. For example, we've discovered 2 warning signs that you should run your eye over to get a better picture of Downer EDI.

After our examination into the nature of Downer EDI's profit, we've come away optimistic for the company. 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. 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 with significant insider holdings to be useful.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.