Eleco's (LON:ELCO) Earnings Are Growing But Is There More To The Story?

As a general rule, we think profitable companies are less risky than companies that lose money. 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 Eleco (LON:ELCO).

It's good to see that over the last twelve months Eleco made a profit of UK£2.93m on revenue of UK£24.9m. Happily, it has grown both its profit and revenue over the last three years, as you can see in the chart below.

Check out our latest analysis for Eleco

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. As a result, we think it's well worth considering what Eleco's cashflow (when compared to its earnings) can tell us about the nature of its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Eleco.

Zooming In On Eleco'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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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.

Over the twelve months to June 2020, Eleco recorded an accrual ratio of -0.17. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of UK£5.6m, well over the UK£2.93m it reported in profit. Eleco shareholders are no doubt pleased that free cash flow improved over the last twelve months.

Our Take On Eleco's Profit Performance

Happily for shareholders, Eleco produced plenty of free cash flow to back up its statutory profit numbers. Because of this, we think Eleco's underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! And on top of that, its earnings per share have grown at 68% per year over the last three years. 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. While it's very important to consider the profit and loss statement, you can also learn a lot about a company by looking at its balance sheet. If you're interested we have a graphic representation of Eleco's balance sheet.

Today we've zoomed in on a single data point to better understand the nature of Eleco's profit. 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. 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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