Why Gentian Diagnostics' (OB:GENT) Earnings Are Weaker Than They Seem

Despite posting strong earnings, Gentian Diagnostics ASA's (OB:GENT) stock didn't move much over the last week. We decided to have a deeper look, and we believe that investors might be worried about several concerning factors that we found.

See our latest analysis for Gentian Diagnostics

A Closer Look At Gentian Diagnostics' Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. While having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Gentian Diagnostics has an accrual ratio of 0.51 for the year to December 2024. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. To wit, it produced free cash flow of kr2.5m during the period, falling well short of its reported profit of kr45.3m. Gentian Diagnostics' free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits. However, as we will discuss below, we can see that the company's accrual ratio has been impacted by its tax situation. This would certainly have contributed to the weak cash conversion. The good news for shareholders is that Gentian Diagnostics' accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

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.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Gentian Diagnostics profited from a tax benefit which contributed kr25m to profit. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. Of course, prima facie it's great to receive a tax benefit. And given that it lost money last year, it seems possible that the benefit is evidence that it now expects to find value in its past tax losses. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal. While we think it's good that the company has booked a tax benefit, it does mean that there's every chance the statutory profit will come in a lot higher than it would be if the income was adjusted for one-off factors.

Our Take On Gentian Diagnostics' Profit Performance

This year, Gentian Diagnostics couldn't match its profit with cashflow. On top of that, the unsustainable nature of tax benefits mean that there's a chance profit may be lower next year, certainly in the absence of strong growth. For all the reasons mentioned above, we think that, at a glance, Gentian Diagnostics' statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. So while earnings quality is important, it's equally important to consider the risks facing Gentian Diagnostics at this point in time. For example, Gentian Diagnostics has 3 warning signs (and 2 which are potentially serious) we think you should know about.

Our examination of Gentian Diagnostics has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks with significant insider holdings to be useful.

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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.