Novo Nordisk's (CPH:NOVO B) Promising Earnings May Rest On Soft Foundations

Despite announcing strong earnings, Novo Nordisk A/S' (CPH:NOVO B) stock was sluggish. We think that the market might be paying attention to some underlying factors that they find to be concerning.

View our latest analysis for Novo Nordisk

Examining Cashflow Against Novo Nordisk'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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Novo Nordisk has an accrual ratio of 0.40 for the year to March 2024. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. To wit, it produced free cash flow of kr.50b during the period, falling well short of its reported profit of kr.89.3b. Novo Nordisk shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months. One positive for Novo Nordisk shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

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.

Our Take On Novo Nordisk's Profit Performance

As we discussed above, we think Novo Nordisk's earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that Novo Nordisk'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 on the bright side, its earnings per share have grown at an extremely impressive rate over the last three years. 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. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. When we did our research, we found 2 warning signs for Novo Nordisk (1 makes us a bit uncomfortable!) that we believe deserve your full attention.

This note has only looked at a single factor that sheds light on the nature of Novo Nordisk'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. 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.