Servotech Power Systems' (NSE:SERVOTECH) Profits May Not Reveal Underlying Issues

Servotech Power Systems Limited's (NSE:SERVOTECH) healthy profit numbers didn't contain any surprises for investors. However the statutory profit number doesn't tell the whole story, and we have found some factors which might be of concern to shareholders.

View our latest analysis for Servotech Power Systems

A Closer Look At Servotech Power Systems' 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'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to March 2024, Servotech Power Systems had an accrual ratio of 0.28. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Over the last year it actually had negative free cash flow of ₹240m, in contrast to the aforementioned profit of ₹117.6m. We also note that Servotech Power Systems' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of ₹240m.

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

Our Take On Servotech Power Systems' Profit Performance

Servotech Power Systems didn't convert much of its profit to free cash flow in the last year, which some investors may consider rather suboptimal. Therefore, it seems possible to us that Servotech Power Systems' true underlying earnings power is actually less than its statutory profit. But on the bright side, its earnings per share have grown at an extremely impressive rate over the last three years. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So while earnings quality is important, it's equally important to consider the risks facing Servotech Power Systems at this point in time. In terms of investment risks, we've identified 2 warning signs with Servotech Power Systems, and understanding these should be part of your investment process.

Today we've zoomed in on a single data point to better understand the nature of Servotech Power Systems' 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks with high insider ownership.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.