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. In this article, we'll look at how useful this year's statutory profit is, when analysing Smartgroup (ASX:SIQ).
While Smartgroup was able to generate revenue of AU$235.4m in the last twelve months, we think its profit result of AU$48.0m was more important. In the chart below, you can see that its profit and revenue have both grown over the last three years, albeit not in the last year.
Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. As a result, we think it's well worth considering what Smartgroup's cashflow (when compared to its earnings) can tell us about the nature of its statutory profit. 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 Smartgroup's 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. 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'.
As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".
Smartgroup has an accrual ratio of -0.11 for the year to June 2020. That indicates that its free cash flow was a fair bit more than its statutory profit. To wit, it produced free cash flow of AU$81m during the period, dwarfing its reported profit of AU$48.0m. Smartgroup shareholders are no doubt pleased that free cash flow improved over the last twelve months.
Our Take On Smartgroup's Profit Performance
As we discussed above, Smartgroup has perfectly satisfactory free cash flow relative to profit. Based on this observation, we consider it likely that Smartgroup's statutory profit actually understates its earnings potential! And on top of that, its earnings per share have grown at 22% per year over the last three years. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. If you want to do dive deeper into Smartgroup, you'd also look into what risks it is currently facing. For example, we've discovered 1 warning sign that you should run your eye over to get a better picture of Smartgroup.
This note has only looked at a single factor that sheds light on the nature of Smartgroup's 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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