Step One Clothing's (ASX:STP) Earnings Are Weaker Than They Seem

Step One Clothing Limited (ASX:STP) just reported some strong earnings, and the market reacted accordingly with a healthy uplift in the share price. However, our analysis suggests that shareholders may be missing some factors that indicate the earnings result was not as good as it looked.

See our latest analysis for Step One Clothing

Zooming In On Step One Clothing's 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. 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'.

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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Step One Clothing has an accrual ratio of 0.72 for the year to December 2022. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Over the last year it actually had negative free cash flow of AU$5.1m, in contrast to the aforementioned profit of AU$6.09m. We also note that Step One Clothing's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of AU$5.1m.

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 Step One Clothing's Profit Performance

As we discussed above, we think Step One Clothing's earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that Step One Clothing's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. On the bright side, the company showed enough improvement to book a profit this year, after losing money last year. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So while earnings quality is important, it's equally important to consider the risks facing Step One Clothing at this point in time. Our analysis shows 4 warning signs for Step One Clothing (2 can't be ignored!) and we strongly recommend you look at them before investing.

This note has only looked at a single factor that sheds light on the nature of Step One Clothing's profit. 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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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.