Investors Can Find Comfort In Somero Enterprises' (LON:SOM) Earnings Quality

Somero Enterprises, Inc.'s (LON:SOM) recent soft profit numbers didn't appear to worry shareholders. However, we think the company is showing some signs that things are more promising than they seem.

See our latest analysis for Somero Enterprises

A Closer Look At Somero Enterprises' 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. 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. While having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Somero Enterprises has an accrual ratio of -0.26 for the year to December 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 US$27m during the period, dwarfing its reported profit of US$18.8m. Somero Enterprises shareholders are no doubt pleased that free cash flow improved over the last twelve months.

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 Somero Enterprises' Profit Performance

As we discussed above, Somero Enterprises' accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Because of this, we think Somero Enterprises' underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! And it's also good to see that its earnings per share have improved a bit over the last three years. 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. Case in point: We've spotted 1 warning sign for Somero Enterprises you should be aware of.

This note has only looked at a single factor that sheds light on the nature of Somero Enterprises' profit. But there is always more to discover if you are capable of focussing your mind on minutiae. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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. 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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