We Think SIG's (LON:SHI) Profit Is Only A Baseline For What They Can Achieve

Investors were underwhelmed by the solid earnings posted by SIG plc (LON:SHI) recently. Our analysis says that investors should be optimistic, as the strong profit is built on solid foundations.

View our latest analysis for SIG

Examining Cashflow Against SIG's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. 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 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. 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, SIG recorded an accrual ratio of -0.23. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of UK£104m during the period, dwarfing its reported profit of UK£15.5m. Given that SIG had negative free cash flow in the prior corresponding period, the trailing twelve month resul of UK£104m would seem to be a step in the right direction. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

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.

How Do Unusual Items Influence Profit?

SIG's profit was reduced by unusual items worth UK£16m 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. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. If SIG 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 SIG's Profit Performance

In conclusion, both SIG's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. After considering all this, we reckon SIG's statutory profit probably understates its earnings potential! So while earnings quality is important, it's equally important to consider the risks facing SIG at this point in time. Our analysis shows 2 warning signs for SIG (1 shouldn't be ignored!) and we strongly recommend you look at them before investing.

After our examination into the nature of SIG's profit, we've come away optimistic for the company. 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. 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.