We Think Carlo Gavazzi Holding's (VTX:GAV) Statutory Profit Might Understate Its Earnings Potential

As a general rule, we think profitable companies are less risky than companies that lose money. 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 Carlo Gavazzi Holding (VTX:GAV).

While Carlo Gavazzi Holding was able to generate revenue of CHF142.0m in the last twelve months, we think its profit result of CHF5.91m was more important. The chart below shows that revenue has been flat over the last three years, while profit has actually declined.

View our latest analysis for Carlo Gavazzi Holding

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. Today, we'll discuss Carlo Gavazzi Holding's free cashflow relative to its earnings, and consider what that tells us about the company. 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 Carlo Gavazzi Holding's 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. The ratio shows us how much a company's profit exceeds its FCF.

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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Carlo Gavazzi Holding has an accrual ratio of -0.19 for the year to September 2020. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of CHF15m during the period, dwarfing its reported profit of CHF5.91m. Carlo Gavazzi Holding shareholders are no doubt pleased that free cash flow improved over the last twelve months.

Our Take On Carlo Gavazzi Holding's Profit Performance

As we discussed above, Carlo Gavazzi Holding's accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Because of this, we think Carlo Gavazzi Holding's underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! On the other hand, its EPS actually shrunk in the last twelve months. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. When we did our research, we found 2 warning signs for Carlo Gavazzi Holding (1 shouldn't be ignored!) that we believe deserve your full attention.

Today we've zoomed in on a single data point to better understand the nature of Carlo Gavazzi Holding's profit. 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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