Here's Why We Don't Think Karelia Tobacco's (ATH:KARE) Statutory Earnings Reflect Its Underlying Earnings Potential

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. 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. This article will consider whether Karelia Tobacco's (ATH:KARE) statutory profits are a good guide to its underlying earnings.

While Karelia Tobacco was able to generate revenue of €657.5m in the last twelve months, we think its profit result of €62.8m was more important. Even though its revenue is down over the last three years, its profit has actually increased, as you can see, below.

See our latest analysis for Karelia Tobacco

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 Karelia Tobacco's free cashflow relative to its earnings, and consider what that tells us about the company. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Karelia Tobacco.

Zooming In On Karelia Tobacco'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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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 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 September 2020, Karelia Tobacco had an accrual ratio of 0.83. 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. In fact, it had free cash flow of €9.3m in the last year, which was a lot less than its statutory profit of €62.8m. Karelia Tobacco's free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits. The good news for shareholders is that Karelia Tobacco's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Our Take On Karelia Tobacco's Profit Performance

As we discussed above, we think Karelia Tobacco'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 Karelia Tobacco's underlying earnings power is lower than its statutory profit. Nonetheless, it's still worth noting that its earnings per share have grown at 7.3% 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. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. For instance, we've identified 2 warning signs for Karelia Tobacco (1 is a bit unpleasant) you should be familiar with.

This note has only looked at a single factor that sheds light on the nature of Karelia Tobacco's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. Some people consider a high return on equity to be a good sign of a quality business. 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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