Compañia Levantina de Edificacion y Obras Publicas' (BME:CLEO) Solid Profits Have Weak Fundamentals

Compañia Levantina de Edificacion y Obras Publicas, S.A. (BME:CLEO) announced strong profits, but the stock was stagnant. Our analysis suggests that shareholders have noticed something concerning in the numbers.

View our latest analysis for Compañia Levantina de Edificacion y Obras Publicas

Zooming In On Compañia Levantina de Edificacion y Obras Publicas' 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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".

Over the twelve months to December 2022, Compañia Levantina de Edificacion y Obras Publicas recorded an accrual ratio of 0.28. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Over the last year it actually had negative free cash flow of €973k, in contrast to the aforementioned profit of €8.07m. We saw that FCF was €1.3m a year ago though, so Compañia Levantina de Edificacion y Obras Publicas has at least been able to generate positive FCF in the past. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio). The good news for shareholders is that Compañia Levantina de Edificacion y Obras Publicas' accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Compañia Levantina de Edificacion y Obras Publicas.

The Impact Of Unusual Items On Profit

Unfortunately (in the short term) Compañia Levantina de Edificacion y Obras Publicas saw its profit reduced by unusual items worth €98k. 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. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. 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. Assuming those unusual expenses don't come up again, we'd therefore expect Compañia Levantina de Edificacion y Obras Publicas to produce a higher profit next year, all else being equal.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Compañia Levantina de Edificacion y Obras Publicas profited from a tax benefit which contributed €2.6m 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 since it previously lost money, it may well simply indicate the realisation of past tax losses. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal.

Our Take On Compañia Levantina de Edificacion y Obras Publicas' Profit Performance

In conclusion, Compañia Levantina de Edificacion y Obras Publicas' accrual ratio suggests that its statutory earnings are not backed by cash flow, in part due to the tax benefit it received; but the fact unusual items actually weighed on profit may create upside if those unusual items do not recur. Based on these factors, we think that Compañia Levantina de Edificacion y Obras Publicas' statutory profits probably make it seem better than it is on an underlying level. If you want to do dive deeper into Compañia Levantina de Edificacion y Obras Publicas, you'd also look into what risks it is currently facing. Every company has risks, and we've spotted 2 warning signs for Compañia Levantina de Edificacion y Obras Publicas (of which 1 is concerning!) you should know about.

Our examination of Compañia Levantina de Edificacion y Obras Publicas has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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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.