Is There More To The Story Than Softcat's (LON:SCT) Earnings Growth?

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. In this article, we'll look at how useful this year's statutory profit is, when analysing Softcat (LON:SCT).

We like the fact that Softcat made a profit of UK£75.7m on its revenue of UK£1.08b, in the last year. One positive is that it has grown both its profit and its revenue, over the last few years.

Check out our latest analysis for Softcat

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. Today, we'll discuss Softcat's free cashflow relative to its earnings, and consider what that tells us about the company. 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 Softcat'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'.

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. While having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to July 2020, Softcat had an accrual ratio of 0.42. That means it didn't generate anywhere near enough free cash flow to match its profit. As a general rule, that bodes poorly for future profitability. To wit, it produced free cash flow of UK£55m during the period, falling well short of its reported profit of UK£75.7m. Softcat shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months.

Our Take On Softcat's Profit Performance

As we discussed above, we think Softcat's earnings were not supported by free cash flow, which might concern some investors. As a result, we think it may well be the case that Softcat's underlying earnings power is lower than its statutory profit. But the good news is that its EPS growth over the last three years has been very impressive. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. If you want to do dive deeper into Softcat, you'd also look into what risks it is currently facing. Our analysis shows 2 warning signs for Softcat (1 shouldn't be ignored!) and we strongly recommend you look at them before investing.

This note has only looked at a single factor that sheds light on the nature of Softcat'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. 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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