Here's Why Savita Oil Technologies's (NSE:SOTL) Statutory Earnings Are Arguably Too Conservative

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. 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 Savita Oil Technologies' (NSE:SOTL) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Savita Oil Technologies made a profit of ₹905.6m on revenue of ₹17.1b. As you can see in the chart below, its profit has declined over the last three years, even though its revenue has increased.

See our latest analysis for Savita Oil Technologies

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. Today, we'll discuss Savita Oil Technologies' 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 Savita Oil Technologies.

Examining Cashflow Against Savita Oil Technologies' 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. 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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Savita Oil Technologies has an accrual ratio of -0.19 for the year to September 2020. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of ₹2.3b during the period, dwarfing its reported profit of ₹905.6m. Savita Oil Technologies shareholders are no doubt pleased that free cash flow improved over the last twelve months.

Our Take On Savita Oil Technologies' Profit Performance

As we discussed above, Savita Oil Technologies' accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Based on this observation, we consider it possible that Savita Oil Technologies' statutory profit actually understates its earnings potential! Unfortunately, though, its earnings per share actually fell back over 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. If you want to do dive deeper into Savita Oil Technologies, you'd also look into what risks it is currently facing. While conducting our analysis, we found that Savita Oil Technologies has 1 warning sign and it would be unwise to ignore this.

Today we've zoomed in on a single data point to better understand the nature of Savita Oil Technologies' profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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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