Shareholders appeared unconcerned with MotorCycle Holdings Limited's (ASX:MTO) lackluster earnings report last week. Our analysis suggests that while the profits are soft, the foundations of the business are strong.
A Closer Look At MotorCycle Holdings' 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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. This ratio tells us how much of a company's profit is not backed by free cashflow.
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. 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".
For the year to December 2020, MotorCycle Holdings had an accrual ratio of -0.26. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of AU$50m, well over the AU$3.27m it reported in profit. MotorCycle Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.
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.
How Do Unusual Items Influence Profit?
MotorCycle Holdings' profit was reduced by unusual items worth AU$24m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. MotorCycle Holdings took a rather significant hit from unusual items in the year to December 2020. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.
Our Take On MotorCycle Holdings' Profit Performance
In conclusion, both MotorCycle Holdings' accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Based on these factors, we think MotorCycle Holdings' underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. To help with this, we've discovered 4 warning signs (1 shouldn't be ignored!) that you ought to be aware of before buying any shares in MotorCycle Holdings.
After our examination into the nature of MotorCycle Holdings' profit, we've come away optimistic for the company. 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. 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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