We Think SThree's (LON:STEM) Statutory Profit Might Understate Its Earnings Potential

Broadly speaking, profitable businesses are less risky than unprofitable ones. That said, the current statutory profit is not always a good guide to a company's underlying profitability. In this article, we'll look at how useful this year's statutory profit is, when analysing SThree (LON:STEM).

We like the fact that SThree made a profit of UK£32.7m on its revenue of UK£1.29b, in the last year. In the chart below, you can see that its profit and revenue have both grown over the last three years, albeit not in the last year.

Check out our latest analysis for SThree

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 SThree'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 SThree'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. 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.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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.

Over the twelve months to May 2020, SThree recorded an accrual ratio of -0.35. 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£67m, well over the UK£32.7m it reported in profit. SThree shareholders are no doubt pleased that free cash flow improved over the last twelve months.

Our Take On SThree's Profit Performance

Happily for shareholders, SThree produced plenty of free cash flow to back up its statutory profit numbers. Because of this, we think SThree's 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. If you'd like to know more about SThree as a business, it's important to be aware of any risks it's facing. At Simply Wall St, we found 2 warning signs for SThree and we think they deserve your attention.

This note has only looked at a single factor that sheds light on the nature of SThree's 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. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying to be useful.

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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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