Is There More To The Story Than Silver Lake Resources' (ASX:SLR) Earnings Growth?

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. 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. Today we'll focus on whether this year's statutory profits are a good guide to understanding Silver Lake Resources (ASX:SLR).

While Silver Lake Resources was able to generate revenue of AU$563.4m in the last twelve months, we think its profit result of AU$256.9m was more important. Happily, it has grown both its profit and revenue over the last three years, as you can see in the chart below.

Check out our latest analysis for Silver Lake Resources

Importantly, statutory profits are not always the best tool for understanding a company's true earnings power, so it's well worth examining profits in a little more detail. So today we'll look at what Silver Lake Resources' cashflow tells us about its earnings, as well as examining how the receipt of a tax benefit has impacted its statutory earnings. 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.

A Closer Look At Silver Lake Resources' 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. 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. 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".

Silver Lake Resources has an accrual ratio of 0.25 for the year to June 2020. Unfortunately, that means its free cash flow fell significantly short of its reported profits. In fact, it had free cash flow of AU$145m in the last year, which was a lot less than its statutory profit of AU$256.9m. At this point we should mention that Silver Lake Resources did manage to increase its free cash flow in the last twelve months Importantly, we note an unusual tax situation, which we discuss below, has impacted the accruals ratio. This would certainly have contributed to the weak cash conversion. One positive for Silver Lake Resources shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Silver Lake Resources profited from a tax benefit which contributed AU$124m to profit. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! Of course, prima facie it's great to receive a tax benefit. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth. So while we think it's great to receive a tax benefit, it does tend to imply an increased risk that the statutory profit overstates the sustainable earnings power of the business.

Our Take On Silver Lake Resources' Profit Performance

Silver Lake Resources' accrual ratio indicates weak cashflow relative to earnings, which perhaps arises in part from the tax benefit it received this year. On top of that, the unsustainable nature of tax benefits mean that there's a chance profit may be lower next year, certainly in the absence of strong growth. For the reasons mentioned above, we think that a perfunctory glance at Silver Lake Resources' statutory profits might make it look better than it really is on an underlying level. If you'd like to know more about Silver Lake Resources as a business, it's important to be aware of any risks it's facing. Be aware that Silver Lake Resources is showing 3 warning signs in our investment analysis and 2 of those make us uncomfortable...

Our examination of Silver Lake Resources has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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 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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