The subdued stock price reaction suggests that National World Plc's (LON:NWOR) strong earnings didn't offer any surprises. We think that investors have missed some encouraging factors underlying the profit figures.
Zooming In On National World'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). 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".
National World has an accrual ratio of -0.31 for the year to July 2022. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of UK£11m, well over the UK£9.30m it reported in profit. National World's free cash flow improved over the last year, which is generally good to see. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio).
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?
National World's profit was reduced by unusual items worth UK£4.1m 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. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. 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. Assuming those unusual expenses don't come up again, we'd therefore expect National World to produce a higher profit next year, all else being equal.
An Unusual Tax Situation
In addition to the notable accrual ratio, we can see that National World received a tax benefit of UK£3.3m. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. We're sure the company was pleased with its tax benefit. And since it previously lost money, it may well simply indicate the realisation of past tax losses. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth. So while we think it's great to receive a tax benefit, it does tend to imply an increased risk that the statutory profit overstates the sustainable earnings power of the business.
Our Take On National World's Profit Performance
In conclusion, both National World's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative, but the presence of a tax benefits may be inflating the numbers in a way that won't persist. Based on these factors, we think National World's earnings potential is at least as good as it seems, and maybe even better! If you want to do dive deeper into National World, you'd also look into what risks it is currently facing. Be aware that National World is showing 3 warning signs in our investment analysis and 1 of those can't be ignored...
Our examination of National World has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. But there are plenty of other ways to inform your opinion of a company. 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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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