Are Aryt Industries's (TLV:ARYT) Statutory Earnings A Good Guide To Its Underlying Profitability?

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. 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. This article will consider whether Aryt Industries' (TLV:ARYT) statutory profits are a good guide to its underlying earnings.

While Aryt Industries was able to generate revenue of ₪64.6m in the last twelve months, we think its profit result of ₪19.6m was more important. In the last few years both its revenue and its profit have fallen, as you can see in the chart below.

Check out our latest analysis for Aryt Industries

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. Therefore, we think it's worth taking a closer look at Aryt Industries' cashflow, as well as examining the impact that unusual items have had on its reported profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Aryt Industries.

Examining Cashflow Against Aryt Industries' 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. The ratio shows us how much a company's profit exceeds its FCF.

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

Aryt Industries has an accrual ratio of -0.37 for the year to June 2020. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of ₪30m, well over the ₪19.6m it reported in profit. Aryt Industries' free cash flow improved over the last year, which is generally good to see. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

How Do Unusual Items Influence Profit?

Surprisingly, given Aryt Industries' accrual ratio implied strong cash conversion, its paper profit was actually boosted by ₪3.8m in unusual items. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And that's as you'd expect, given these boosts are described as 'unusual'. If Aryt Industries doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Aryt Industries' Profit Performance

In conclusion, Aryt Industries' accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Considering all the aforementioned, we'd venture that Aryt Industries' profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. In terms of investment risks, we've identified 3 warning signs with Aryt Industries, and understanding them should be part of your investment process.

Our examination of Aryt Industries has focussed on certain factors that can make its earnings look better than they are. 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. 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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