EZZ Life Science Holdings' (ASX:EZZ) Promising Earnings May Rest On Soft Foundations

Unsurprisingly, EZZ Life Science Holdings Limited's (ASX:EZZ) stock price was strong on the back of its healthy earnings report. However, our analysis suggests that shareholders may be missing some factors that indicate the earnings result was not as good as it looked.

View our latest analysis for EZZ Life Science Holdings

A Closer Look At EZZ Life Science Holdings' Earnings

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

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

Over the twelve months to December 2022, EZZ Life Science Holdings recorded an accrual ratio of 0.76. Ergo, its free cash flow is significantly weaker than its profit. Statistically speaking, that's a real negative for future earnings. In fact, it had free cash flow of AU$932k in the last year, which was a lot less than its statutory profit of AU$2.51m. Notably, EZZ Life Science Holdings had negative free cash flow last year, so the AU$932k it produced this year was a welcome improvement.

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.

Our Take On EZZ Life Science Holdings' Profit Performance

As we discussed above, we think EZZ Life Science Holdings' earnings were not supported by free cash flow, which might concern some investors. As a result, we think it may well be the case that EZZ Life Science Holdings' underlying earnings power is lower than its statutory profit. But the happy news is that, while acknowledging we have to look beyond the statutory numbers, those numbers are still improving, with EPS growing at a very high rate over the 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 EZZ Life Science Holdings at this point in time. To that end, you should learn about the 2 warning signs we've spotted with EZZ Life Science Holdings (including 1 which makes us a bit uncomfortable).

This note has only looked at a single factor that sheds light on the nature of EZZ Life Science Holdings' 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. 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. 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.