Here's Why We Think Watches of Switzerland Group's (LON:WOSG) Statutory Earnings Might Be Conservative

Broadly speaking, profitable businesses are less risky than 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 Watches of Switzerland Group (LON:WOSG).

It's good to see that over the last twelve months Watches of Switzerland Group made a profit of UK£37.4m on revenue of UK£796.1m.

Check out our latest analysis for Watches of Switzerland Group

Not all profits are equal, and we can learn more about the nature of a company's past profitability by diving deeper into the financial statements. Therefore, we think it's worth taking a closer look at Watches of Switzerland Group's cashflow, as well as examining the impact that unusual items have had on its reported profit. 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 Watches of Switzerland Group'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. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to October 2020, Watches of Switzerland Group had an accrual ratio of -0.42. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of UK£146m during the period, dwarfing its reported profit of UK£37.4m. Watches of Switzerland Group's free cash flow improved over the last year, which is generally good to see. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

How Do Unusual Items Influence Profit?

Watches of Switzerland Group's profit was reduced by unusual items worth UK£9.1m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. Assuming those unusual expenses don't come up again, we'd therefore expect Watches of Switzerland Group to produce a higher profit next year, all else being equal.

Our Take On Watches of Switzerland Group's Profit Performance

Considering both Watches of Switzerland Group's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. After considering all this, we reckon Watches of Switzerland Group's statutory profit probably understates its earnings potential! If you want to do dive deeper into Watches of Switzerland Group, you'd also look into what risks it is currently facing. In terms of investment risks, we've identified 2 warning signs with Watches of Switzerland Group, and understanding these bad boys should be part of your investment process.

Our examination of Watches of Switzerland 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 are plenty of other ways to inform your opinion of a company. Some people consider a high return on equity to be a good sign of a quality business. 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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