Should You Use Adacel Technologies's (ASX:ADA) Statutory Earnings To Analyse It?

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. Today we'll focus on whether this year's statutory profits are a good guide to understanding Adacel Technologies (ASX:ADA).

It's good to see that over the last twelve months Adacel Technologies made a profit of AU$3.63m on revenue of AU$39.7m.

See our latest analysis for Adacel Technologies

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 Adacel Technologies' cashflow tells us about its earnings, as well as examining how the receipt of a tax benefit has impacted its statutory earnings. 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.

A Closer Look At Adacel Technologies' Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. 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 June 2020, Adacel Technologies had an accrual ratio of -0.26. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of AU$5.3m, well over the AU$3.63m it reported in profit. Notably, Adacel Technologies had negative free cash flow last year, so the AU$5.3m it produced this year was a welcome improvement. However, as we will discuss below, we can see that the company's accrual ratio has been impacted by its tax situation.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Adacel Technologies profited from a tax benefit which contributed AU$1.4m to profit. This is meaningful because companies usually pay tax rather than receive tax benefits. Of course, prima facie it's great to receive a tax benefit. And given that it lost money last year, it seems possible that the benefit is evidence that it now expects to find value in its past tax losses. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth. So while we think it's great to receive a tax benefit, it does tend to imply an increased risk that the statutory profit overstates the sustainable earnings power of the business.

Our Take On Adacel Technologies' Profit Performance

While Adacel Technologies' accrual ratio stands testament to its strong cashflow, and indicates good quality earnings, the fact that it received a tax benefit suggests that this year's profit may not be a great guide to its sustainable profit run-rate. After taking into account all these factors, we think that Adacel Technologies' statutory results are a decent reflection of its underlying earnings power. If you'd like to know more about Adacel Technologies as a business, it's important to be aware of any risks it's facing. Be aware that Adacel Technologies is showing 4 warning signs in our investment analysis and 1 of those is significant...

Our examination of Adacel Technologies has focussed on certain factors that can make its earnings look better than they are. But there are plenty of other ways to inform your opinion of a company. Some people consider a high return on equity to be a good sign of a quality business. 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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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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