McGrath Limited (ASX:MEA) just reported some strong earnings, and the market rewarded them with a positive share price move. However, our analysis suggests that shareholders may be missing some factors that indicate the earnings result was not as good as it looked.
Zooming In On McGrath's Earnings
One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.
Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.
For the year to December 2020, McGrath had an accrual ratio of -0.67. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of AU$21m in the last year, which was a lot more than its statutory profit of AU$9.84m. Notably, McGrath had negative free cash flow last year, so the AU$21m it produced this year was a welcome improvement. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.
Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of McGrath.
How Do Unusual Items Influence Profit?
While the accrual ratio might bode well, we also note that McGrath's profit was boosted by unusual items worth AU$4.3m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And, after all, that's exactly what the accounting terminology implies. McGrath had a rather significant contribution from unusual items relative to its profit to December 2020. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.
Our Take On McGrath's Profit Performance
In conclusion, McGrath's accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Given the contrasting considerations, we don't have a strong view as to whether McGrath's profits are an apt reflection of its underlying potential for profit. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For example - McGrath has 4 warning signs we think you should be aware of.
Our examination of McGrath has focussed on certain factors that can make its earnings look better than they are. 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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