Are Serco Group's (LON:SRP) Statutory Earnings A Good Reflection Of Its Earnings Potential?

Broadly speaking, profitable businesses are less risky than unprofitable ones. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. Today we'll focus on whether this year's statutory profits are a good guide to understanding Serco Group (LON:SRP).

While Serco Group was able to generate revenue of UK£3.60b in the last twelve months, we think its profit result of UK£122.5m was more important. The good news is that the company managed to grow its revenue over the last three years, and also move from loss-making to profitable.

View our latest analysis for Serco Group

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. So today we'll look at what Serco Group's cashflow tells us about the quality of its earnings. 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 Serco Group's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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.

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

Serco Group has an accrual ratio of -0.11 for the year to June 2020. That indicates that its free cash flow was a fair bit more than its statutory profit. Indeed, in the last twelve months it reported free cash flow of UK£201m, well over the UK£122.5m it reported in profit. Serco Group shareholders are no doubt pleased that free cash flow improved over the last twelve months.

Our Take On Serco Group's Profit Performance

As we discussed above, Serco Group has perfectly satisfactory free cash flow relative to profit. Based on this observation, we consider it likely that Serco Group's statutory profit actually understates its earnings potential! Furthermore, it has done a great job growing EPS over the last year. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So while earnings quality is important, it's equally important to consider the risks facing Serco Group at this point in time. Our analysis shows 2 warning signs for Serco Group (1 shouldn't be ignored!) and we strongly recommend you look at these bad boys before investing.

This note has only looked at a single factor that sheds light on the nature of Serco Group'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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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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