TerraCom's (ASX:TER) Strong Earnings Are Of Good Quality

TerraCom Limited (ASX:TER) recently posted some strong earnings, and the market responded positively. We did some digging and found some further encouraging factors that investors will like.

Check out our latest analysis for TerraCom

A Closer Look At TerraCom'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. 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. 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 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

TerraCom has an accrual ratio of -0.24 for the year to December 2021. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of AU$72m, well over the AU$18.1m it reported in profit. Given that TerraCom had negative free cash flow in the prior corresponding period, the trailing twelve month resul of AU$72m would seem to be a step in the right direction.

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

Our Take On TerraCom's Profit Performance

Happily for shareholders, TerraCom produced plenty of free cash flow to back up its statutory profit numbers. Because of this, we think TerraCom's underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! And one can definitely find a positive in the fact that it made a profit this year, despite losing money last year. 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 TerraCom at this point in time. For instance, we've identified 3 warning signs for TerraCom (2 are potentially serious) you should be familiar with.

This note has only looked at a single factor that sheds light on the nature of TerraCom's 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. 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.