Stock Analysis

Franchetti's (BIT:FCH) Earnings Are Of Questionable Quality

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BIT:FCH
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Investors were disappointed with Franchetti S.p.A.'s (BIT:FCH) earnings, despite the strong profit numbers. We think that the market might be paying attention to some underlying factors are concerning.

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BIT:FCH Earnings and Revenue History September 22nd 2023

Examining Cashflow Against Franchetti'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'.

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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to June 2023, Franchetti had an accrual ratio of 0.79. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of €1.7m, in contrast to the aforementioned profit of €1.22m. We also note that Franchetti's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of €1.7m.

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.

Our Take On Franchetti's Profit Performance

As we have made quite clear, we're a bit worried that Franchetti didn't back up the last year's profit with free cashflow. As a result, we think it may well be the case that Franchetti's underlying earnings power is lower than its statutory profit. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. So while earnings quality is important, it's equally important to consider the risks facing Franchetti at this point in time. For example, we've found that Franchetti has 4 warning signs (1 can't be ignored!) that deserve your attention before going any further with your analysis.

This note has only looked at a single factor that sheds light on the nature of Franchetti's 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 that insiders are buying.

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