Vita Life Sciences (ASX:VLS) Is Growing Earnings But Are They A Good Guide?

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. That said, the current statutory profit is not always a good guide to a company's underlying profitability. This article will consider whether Vita Life Sciences' (ASX:VLS) statutory profits are a good guide to its underlying earnings.

We like the fact that Vita Life Sciences made a profit of AU$5.07m on its revenue of AU$44.6m, in the last year. Happily, it has grown both its profit and revenue over the last three years, as you can see in the chart below.

See our latest analysis for Vita Life Sciences

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 Vita Life Sciences' cashflow tells us about the quality of its earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Vita Life Sciences.

Zooming In On Vita Life Sciences' 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 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. 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 2020, Vita Life Sciences had an accrual ratio of -0.15. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of AU$7.0m during the period, dwarfing its reported profit of AU$5.07m. Vita Life Sciences shareholders are no doubt pleased that free cash flow improved over the last twelve months.

Our Take On Vita Life Sciences' Profit Performance

As we discussed above, Vita Life Sciences has perfectly satisfactory free cash flow relative to profit. Because of this, we think Vita Life Sciences' earnings potential is at least as good as it seems, and maybe even better! Better yet, its EPS are growing strongly, which is nice to see. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Be aware that Vita Life Sciences is showing 3 warning signs in our investment analysis and 1 of those is concerning...

Today we've zoomed in on a single data point to better understand the nature of Vita Life Sciences' 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. 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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