We Think Norcros's (LON:NXR) Statutory Profit Might Understate Its Earnings Potential

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. That said, the current statutory profit is not always a good guide to a company's underlying profitability. This article will consider whether Norcros' (LON:NXR) statutory profits are a good guide to its underlying earnings.

We like the fact that Norcros made a profit of UK£3.20m on its revenue of UK£296.1m, in the last year. As you can see in the chart below, its profit has declined over the last three years, even though its revenue has increased.

Check out our latest analysis for Norcros

Not all profits are equal, and we can learn more about the nature of a company's past profitability by diving deeper into the financial statements. As a result, today we're going to take a closer look at Norcros' cashflow, and unusual items, with a view to understanding what these might tell us about its statutory profit. 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.

Examining Cashflow Against Norcros' 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.

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. 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 September 2020, Norcros recorded an accrual ratio of -0.26. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of UK£41m, well over the UK£3.20m it reported in profit. Norcros shareholders are no doubt pleased that free cash flow improved over the last twelve months. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

The Impact Of Unusual Items On Profit

Norcros' profit was reduced by unusual items worth UK£2.3m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. If Norcros 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 Norcros' Profit Performance

In conclusion, both Norcros' accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. After considering all this, we reckon Norcros' statutory profit probably understates its earnings potential! If you want to do dive deeper into Norcros, you'd also look into what risks it is currently facing. For example - Norcros has 3 warning signs we think you should be aware of.

Our examination of Norcros has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. But there are plenty of other ways to inform your opinion of a company. 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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