System1 Group's (LON:SYS1) Solid Earnings Have Been Accounted For Conservatively

System1 Group PLC (LON:SYS1) announced a healthy earnings result recently, and the market rewarded it with a strong stock price reaction. According to our analysis of the report, the strong headline profit numbers are supported by strong earnings fundamentals.

See our latest analysis for System1 Group

A Closer Look At System1 Group's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to March 2021, System1 Group had an accrual ratio of -1.92. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of UK£3.9m during the period, dwarfing its reported profit of UK£1.69m. System1 Group's free cash flow improved over the last year, which is generally good to see. 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?

System1 Group's profit was reduced by unusual items worth UK£937k 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. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. If System1 Group 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 System1 Group's Profit Performance

In conclusion, both System1 Group's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. After considering all this, we reckon System1 Group's statutory profit probably understates its earnings potential! If you'd like to know more about System1 Group as a business, it's important to be aware of any risks it's facing. Every company has risks, and we've spotted 4 warning signs for System1 Group (of which 1 makes us a bit uncomfortable!) you should know about.

Our examination of System1 Group has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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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