Broadly speaking, profitable businesses are less risky than 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. In this article, we'll look at how useful this year's statutory profit is, when analysing Sopharma Trading AD (BUL:SO5).
It's good to see that over the last twelve months Sopharma Trading AD made a profit of лв9.77m on revenue of лв1.07b. 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.
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.
A Closer Look At 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.
That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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. 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 September 2020, Sopharma Trading AD had an accrual ratio of 0.82. 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 лв208m, in contrast to the aforementioned profit of лв9.77m. We also note that Sopharma Trading AD's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of лв208m.
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 15% 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'd like to know more about Sopharma Trading AD as a business, it's important to be aware of any risks it's facing. At Simply Wall St, we found 3 warning signs for Sopharma Trading AD and we think they deserve your attention.
This note has only looked at a single factor that sheds light on the nature of Sopharma Trading AD'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. 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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