ABB Power Products and Systems India's (NSE:POWERINDIA) Soft Earnings Are Actually Better Than They Appear

Shareholders appeared unconcerned with ABB Power Products and Systems India Limited's (NSE:POWERINDIA) lackluster earnings report last week. We did some digging, and we believe the earnings are stronger than they seem.

View our latest analysis for ABB Power Products and Systems India

Examining Cashflow Against ABB Power Products and Systems India's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. 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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

ABB Power Products and Systems India has an accrual ratio of -0.56 for the year to December 2020. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of ₹5.2b in the last year, which was a lot more than its statutory profit of ₹998.0m. Notably, ABB Power Products and Systems India had negative free cash flow last year, so the ₹5.2b it produced this year was a welcome improvement. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of ABB Power Products and Systems India.

The Impact Of Unusual Items On Profit

ABB Power Products and Systems India's profit was reduced by unusual items worth ₹355m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. If ABB Power Products and Systems India doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On ABB Power Products and Systems India's Profit Performance

Considering both ABB Power Products and Systems India's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. After considering all this, we reckon ABB Power Products and Systems India's statutory profit probably understates its earnings potential! If you want to do dive deeper into ABB Power Products and Systems India, you'd also look into what risks it is currently facing. For example, ABB Power Products and Systems India has 5 warning signs (and 1 which is a bit concerning) we think you should know about.

Our examination of ABB Power Products and Systems India has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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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