Here's Why We Don't Think Israel Shipyards Industries's (TLV:ISHI) Statutory Earnings Reflect Its Underlying Earnings Potential

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 Israel Shipyards Industries' (TLV:ISHI) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Israel Shipyards Industries made a profit of ₪6.36b on revenue of ₪789.3m.

View our latest analysis for Israel Shipyards Industries

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. So today we'll look at what Israel Shipyards Industries' cashflow tells us about the quality of its earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Israel Shipyards Industries.

Examining Cashflow Against Israel Shipyards 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. 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 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Israel Shipyards Industries has an accrual ratio of 18.15 for the year to September 2020. Ergo, its free cash flow is significantly weaker than its profit. As a general rule, that bodes poorly for future profitability. In fact, it had free cash flow of ₪22m in the last year, which was a lot less than its statutory profit of ₪6.36b. Israel Shipyards Industries 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 Israel Shipyards Industries' Profit Performance

As we have made quite clear, we're a bit worried that Israel Shipyards Industries didn't back up the last year's profit with free cashflow. As a result, we think it may well be the case that Israel Shipyards Industries' underlying earnings power is lower than its statutory profit. But at least holders can take some solace from the 31% EPS growth in the last year. 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. So while earnings quality is important, it's equally important to consider the risks facing Israel Shipyards Industries at this point in time. While conducting our analysis, we found that Israel Shipyards Industries has 1 warning sign and it would be unwise to ignore it.

Today we've zoomed in on a single data point to better understand the nature of Israel Shipyards Industries' profit. 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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