Some Investors May Be Willing To Look Past Sonata Software's (NSE:SONATSOFTW) Soft Earnings

Soft earnings didn't appear to concern Sonata Software Limited's (NSE:SONATSOFTW) shareholders over the last week. We did some digging, and we believe the earnings are stronger than they seem.

Check out our latest analysis for Sonata Software

Zooming In On Sonata Software's 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). The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. 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. 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.

Sonata Software has an accrual ratio of -0.16 for the year to September 2024. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of ₹5.0b, well over the ₹2.76b it reported in profit. Sonata Software's free cash flow improved over the last year, which is generally good to see. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

The Impact Of Unusual Items On Profit

Sonata Software's profit was reduced by unusual items worth ₹1.5b 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 that's hardly a surprise given these line items are considered unusual. If Sonata Software 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 Sonata Software's Profit Performance

In conclusion, both Sonata Software's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Based on these factors, we think Sonata Software's earnings potential is at least as good as it seems, and maybe even better! So while earnings quality is important, it's equally important to consider the risks facing Sonata Software at this point in time. For example - Sonata Software has 4 warning signs we think you should be aware of.

After our examination into the nature of Sonata Software's profit, we've come away optimistic for the company. 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 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.