Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. 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. This article will consider whether Orange Belgium’s (EBR:OBEL) statutory profits are a good guide to its underlying earnings.
While Orange Belgium was able to generate revenue of €1.34b in the last twelve months, we think its profit result of €45.9m was more important. The chart below shows how it has grown revenue over the last three years, but that profit has declined.
Not all profits are equal, and we can learn more about the nature of a company’s past profitability by diving deeper into the financial statements. As a result, today we’re going to take a closer look at Orange Belgium’s cashflow, and unusual items, with a view to understanding what these might tell us about its statutory profit. 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 Orange Belgium’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. 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. 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. To quote a 2014 paper by Lewellen and Resutek, “firms with higher accruals tend to be less profitable in the future”.
Orange Belgium has an accrual ratio of -0.19 for the year to June 2020. 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 €198m, well over the €45.9m it reported in profit. Orange Belgium’s free cash flow improved over the last year, which is generally good to see. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.
How Do Unusual Items Influence Profit?
Orange Belgium’s profit was reduced by unusual items worth €22m 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. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that’s exactly what the accounting terminology implies. Assuming those unusual expenses don’t come up again, we’d therefore expect Orange Belgium to produce a higher profit next year, all else being equal.
Our Take On Orange Belgium’s Profit Performance
In conclusion, both Orange Belgium’s accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. After considering all this, we reckon Orange Belgium’s statutory profit probably understates its earnings potential! If you’d like to know more about Orange Belgium as a business, it’s important to be aware of any risks it’s facing. In terms of investment risks, we’ve identified 3 warning signs with Orange Belgium, and understanding these should be part of your investment process.
Our examination of Orange Belgium has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. But there is always more to discover if you are capable of focussing your mind on minutiae. 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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