Here's Why We Don't Think Primorus Investments's (LON:PRIM) Statutory Earnings Reflect Its Underlying Earnings Potential

Statistically speaking, it is less risky to invest in profitable companies than in 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 Primorus Investments (LON:PRIM).

While Primorus Investments was able to generate revenue of UK£3.89m in the last twelve months, we think its profit result of UK£3.31m was more important. The chart below shows that revenue has improved over the last three years, and, even better, the company has moved from unprofitable to profitable.

View our latest analysis for Primorus Investments

Importantly, statutory profits are not always the best tool for understanding a company's true earnings power, so it's well worth examining profits in a little more detail. Today, we'll discuss Primorus Investments' free cashflow relative to its earnings, and consider what that tells us about the company. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Primorus Investments.

Zooming In On Primorus Investments' 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. 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".

For the year to June 2020, Primorus Investments had an accrual ratio of 0.46. Ergo, its free cash flow is significantly weaker than its profit. As a general rule, that bodes poorly for future profitability. Indeed, in the last twelve months it reported free cash flow of UK£555k, which is significantly less than its profit of UK£3.31m. We note, however, that Primorus Investments grew its free cash flow over the last year. The good news for shareholders is that Primorus Investments' accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Our Take On Primorus Investments' Profit Performance

As we have made quite clear, we're a bit worried that Primorus Investments didn't back up the last year's profit with free cashflow. For this reason, we think that Primorus Investments' statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. The good news is that it earned a profit in the last twelve months, despite its previous loss. 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. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Case in point: We've spotted 3 warning signs for Primorus Investments you should be mindful of and 2 of them are a bit unpleasant.

This note has only looked at a single factor that sheds light on the nature of Primorus Investments' 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. 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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