Stock Analysis

Is There More To The Story Than Water Intelligence's (LON:WATR) Earnings Growth?

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AIM:WATR
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Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. That said, the current statutory profit is not always a good guide to a company's underlying profitability. Today we'll focus on whether this year's statutory profits are a good guide to understanding Water Intelligence (LON:WATR).

While Water Intelligence was able to generate revenue of US$33.6m in the last twelve months, we think its profit result of US$2.05m was more important. One positive is that it has grown both its profit and its revenue, over the last few years.

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AIM:WATR Earnings and Revenue History December 22nd 2020

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. Today, we'll discuss Water Intelligence's free cashflow relative to its earnings, and consider what that tells us about the company. 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.

Zooming In On Water Intelligence'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. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Water Intelligence has an accrual ratio of -0.19 for the year to June 2020. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of US$5.0m in the last year, which was a lot more than its statutory profit of US$2.05m. Given that Water Intelligence had negative free cash flow in the prior corresponding period, the trailing twelve month resul of US$5.0m would seem to be a step in the right direction.

Our Take On Water Intelligence's Profit Performance

Happily for shareholders, Water Intelligence produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that Water Intelligence's statutory profit actually understates its earnings potential! And on top of that, its earnings per share have grown at an extremely impressive rate over the last three years. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. At Simply Wall St, we found 1 warning sign for Water Intelligence and we think they deserve your attention.

This note has only looked at a single factor that sheds light on the nature of Water Intelligence's 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. 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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