Here's Why We Don't Think Gatekeeper Systems's (CVE:GSI) Statutory Earnings Reflect Its Underlying Earnings Potential

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. In this article, we'll look at how useful this year's statutory profit is, when analysing Gatekeeper Systems (CVE:GSI).

We like the fact that Gatekeeper Systems made a profit of CA$3.58m on its revenue of CA$20.3m, in the last year. The good news is that the company managed to grow its revenue over the last three years, and also move from loss-making to profitable.

Check out our latest analysis for Gatekeeper Systems

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. So today we'll look at what Gatekeeper Systems' cashflow tells us about its earnings, as well as examining how the receipt of a tax benefit has impacted its statutory earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Gatekeeper Systems.

A Closer Look At Gatekeeper Systems' 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). 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. 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. 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".

Gatekeeper Systems has an accrual ratio of 0.69 for the year to August 2020. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. In the last twelve months it actually had negative free cash flow, with an outflow of CA$2.1m despite its profit of CA$3.58m, mentioned above. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CA$2.1m, this year, indicates high risk. However, as we will discuss below, we can see that the company's accrual ratio has been impacted by its tax situation. This would certainly have contributed to the weak cash conversion.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Gatekeeper Systems profited from a tax benefit which contributed CA$1.5m to profit. This is meaningful because companies usually pay tax rather than receive tax benefits. The receipt of a tax benefit is obviously a good thing, on its own. 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, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal.

Our Take On Gatekeeper Systems' Profit Performance

This year, Gatekeeper Systems couldn't match its profit with cashflow. If the tax benefit is not repeated, then profit would drop next year, all else being equal. Considering all this we'd argue Gatekeeper Systems' profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Gatekeeper Systems at this point in time. To help with this, we've discovered 4 warning signs (1 can't be ignored!) that you ought to be aware of before buying any shares in Gatekeeper Systems.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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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