RWE's (ETR:RWE) Shareholders Have More To Worry About Than Only Soft Earnings

Following the release of a lackluster earnings report from RWE Aktiengesellschaft (ETR:RWE) the stock price made a strong positive move. Our analysis suggests that there are some positive factors lying below the troubling profit numbers which investors are finding comfort in.

View our latest analysis for RWE

Zooming In On RWE'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. 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 September 2024, RWE had an accrual ratio of 0.31. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. In the last twelve months it actually had negative free cash flow, with an outflow of €10.0b despite its profit of €2.82b, mentioned above. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of €10.0b, this year, indicates high risk. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

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.

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) RWE saw its profit reduced by unusual items worth €1.6b. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. If RWE doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On RWE's Profit Performance

In conclusion, RWE's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Having considered these factors, we don't think RWE's statutory profits give an overly harsh view of the business. So while earnings quality is important, it's equally important to consider the risks facing RWE at this point in time. Case in point: We've spotted 3 warning signs for RWE you should be mindful of and 2 of these can't be ignored.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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 with significant insider holdings to be useful.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.