We Wouldn't Rely On Sopharma Trading AD's (BUL:SO5) Statutory Earnings As A Guide

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. That said, the current statutory profit is not always a good guide to a company's underlying profitability. In this article, we'll look at how useful this year's statutory profit is, when analysing Sopharma Trading AD (BUL:SO5).

While Sopharma Trading AD was able to generate revenue of лв1.00b in the last twelve months, we think its profit result of лв10.6m was more important. We can see in the depiction below that while it did manage to grow its revenue over the last three years, profit has been pretty flat.

View our latest analysis for Sopharma Trading AD

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. Today, we'll discuss Sopharma Trading AD's free cashflow relative to its earnings, and consider what that tells us about the company. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Sopharma Trading AD.

Zooming In On Sopharma Trading AD's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to March 2020, Sopharma Trading AD had an accrual ratio of 0.87. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of лв216.5m, in contrast to the aforementioned profit of лв10.6m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of лв216.5m, this year, indicates high risk.

Our Take On Sopharma Trading AD's Profit Performance

As we have made quite clear, we're a bit worried that Sopharma Trading AD didn't back up the last year's profit with free cashflow. For this reason, we think that Sopharma Trading AD's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But at least holders can take some solace from the 10% EPS growth in the last year. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. If you want to do dive deeper into Sopharma Trading AD, you'd also look into what risks it is currently facing. For example, we've found that Sopharma Trading AD has 4 warning signs (3 shouldn't be ignored!) that deserve your attention before going any further with your analysis.

This note has only looked at a single factor that sheds light on the nature of Sopharma Trading AD's profit. 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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