AS Merko Ehitus' (TAL:MRK1T) Strong Earnings Are Of Good Quality

The subdued stock price reaction suggests that AS Merko Ehitus' (TAL:MRK1T) strong earnings didn't offer any surprises. Our analysis suggests that investors might be missing some promising details.

Check out our latest analysis for AS Merko Ehitus

A Closer Look At AS Merko Ehitus' 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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to December 2023, AS Merko Ehitus had an accrual ratio of -0.31. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of €114m during the period, dwarfing its reported profit of €46.0m. Given that AS Merko Ehitus had negative free cash flow in the prior corresponding period, the trailing twelve month resul of €114m would seem to be a step in the right direction.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of AS Merko Ehitus.

Our Take On AS Merko Ehitus' Profit Performance

As we discussed above, AS Merko Ehitus' accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Based on this observation, we consider it possible that AS Merko Ehitus' statutory profit actually understates its earnings potential! Better yet, its EPS are growing strongly, which is nice to see. 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. So while earnings quality is important, it's equally important to consider the risks facing AS Merko Ehitus at this point in time. Case in point: We've spotted 1 warning sign for AS Merko Ehitus you should be aware of.

Today we've zoomed in on a single data point to better understand the nature of AS Merko Ehitus' 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.