We Wouldn't Rely On Clinuvel Pharmaceuticals's (ASX:CUV) Statutory Earnings As A Guide

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. 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 Clinuvel Pharmaceuticals (ASX:CUV).

We like the fact that Clinuvel Pharmaceuticals made a profit of AU$16.6m on its revenue of AU$32.6m, in the last year. Happily, it has grown both its profit and revenue over the last three years (though we note its profit is down over the last year).

See our latest analysis for Clinuvel Pharmaceuticals

Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. Thus, we will today look at Clinuvel Pharmaceuticals' cashflow relative to its earnings, and consider how a tax benefit has impacted 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.

Zooming In On Clinuvel Pharmaceuticals' 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to June 2020, Clinuvel Pharmaceuticals recorded an accrual ratio of 0.68. Ergo, its free cash flow is significantly weaker than its profit. Statistically speaking, that's a real negative for future earnings. To wit, it produced free cash flow of AU$13m during the period, falling well short of its reported profit of AU$16.6m. Clinuvel Pharmaceuticals shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over 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. The good news for shareholders is that Clinuvel Pharmaceuticals' accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. 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 Clinuvel Pharmaceuticals profited from a tax benefit which contributed AU$3.5m to profit. This is meaningful because companies usually pay tax rather than receive tax benefits. The receipt of a tax benefit is obviously a good thing, on its own. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal. 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 Clinuvel Pharmaceuticals' Profit Performance

Clinuvel Pharmaceuticals' accrual ratio indicates weak cashflow relative to earnings, which perhaps arises in part from the tax benefit it received this year. If the tax benefit is not repeated, then profit would drop next year, all else being equal. Considering all this we'd argue Clinuvel Pharmaceuticals' profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into Clinuvel Pharmaceuticals, you'd also look into what risks it is currently facing. For example - Clinuvel Pharmaceuticals has 1 warning sign we think you should be aware of.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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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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