Transmetro's (ASX:TCO) Promising Earnings May Rest On Soft Foundations

Unsurprisingly, Transmetro Corporation Limited's (ASX:TCO) stock price was strong on the back of its healthy earnings report. We did some analysis and think that investors are missing some details hidden beneath the profit numbers.

Check out our latest analysis for Transmetro

Zooming In On Transmetro's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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'.

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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to June 2022, Transmetro had an accrual ratio of -0.15. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of AU$5.8m during the period, dwarfing its reported profit of AU$3.43m. Transmetro's free cash flow improved over the last year, which is generally good to see. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Transmetro.

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Transmetro's profit was boosted by unusual items worth AU$2.4m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And, after all, that's exactly what the accounting terminology implies. We can see that Transmetro's positive unusual items were quite significant relative to its profit in the year to June 2022. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Transmetro's Profit Performance

Transmetro'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. Based on these factors, we think it's very unlikely that Transmetro's statutory profits make it seem much weaker than it is. If you'd like to know more about Transmetro as a business, it's important to be aware of any risks it's facing. Case in point: We've spotted 4 warning signs for Transmetro you should be mindful of and 2 of these bad boys shouldn't be ignored.

Our examination of Transmetro has focussed on certain factors that can make its earnings look better than they are. 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. 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.