We Think Card Factory's (LON:CARD) Statutory Profit Might Understate Its Earnings Potential

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. Today we'll focus on whether this year's statutory profits are a good guide to understanding Card Factory (LON:CARD).

It's good to see that over the last twelve months Card Factory made a profit of UK£14.4m on revenue of UK£356.4m. The chart below shows that both revenue and profit have declined over the last three years.

View our latest analysis for Card Factory

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. So today we'll look at what Card Factory'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.

Examining Cashflow Against Card Factory's 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. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to July 2020, Card Factory recorded an accrual ratio of -0.22. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of UK£95m during the period, dwarfing its reported profit of UK£14.4m. Card Factory's free cash flow improved over the last year, which is generally good to see.

Our Take On Card Factory's Profit Performance

Happily for shareholders, Card Factory produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that Card Factory's statutory profit actually understates its earnings potential! Unfortunately, though, its earnings per share actually fell back over the last year. 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. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. At Simply Wall St, we found 3 warning signs for Card Factory and we think they deserve your attention.

Today we've zoomed in on a single data point to better understand the nature of Card Factory'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. 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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