Wellington Drive Technologies' (NZSE:WDT) Earnings Are Of Questionable Quality

Wellington Drive Technologies Limited (NZSE:WDT) announced strong profits, but the stock was stagnant. Our analysis suggests that shareholders have noticed something concerning in the numbers.

Check out our latest analysis for Wellington Drive Technologies

Examining Cashflow Against Wellington Drive Technologies' Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. 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 December 2021, Wellington Drive Technologies had an accrual ratio of 0.28. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. In fact, it had free cash flow of NZ$1.7m in the last year, which was a lot less than its statutory profit of NZ$5.43m. Given that Wellington Drive Technologies had negative free cash flow in the prior corresponding period, the trailing twelve month resul of NZ$1.7m would seem to be a step in the right direction. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Wellington Drive Technologies.

How Do Unusual Items Influence Profit?

Wellington Drive Technologies' profit suffered from unusual items, which reduced profit by NZ$701k in the last twelve months. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. 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, after all, that's exactly what the accounting terminology implies. In the twelve months to December 2021, Wellington Drive Technologies had a big unusual items expense. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Wellington Drive Technologies profited from a tax benefit which contributed NZ$6.0m 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 since it previously lost money, it may well simply indicate the realisation of past tax losses. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. 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 Wellington Drive Technologies' Profit Performance

Summing up, Wellington Drive Technologies' unusual items suggest that its statutory earnings were temporarily depressed, while its tax benefit is having the opposite effect, and its accrual ratio indicates a lack of free cash flow relative to profit. Based on these factors, we think that Wellington Drive Technologies' statutory profits probably make it seem better than it is on an underlying level. So while earnings quality is important, it's equally important to consider the risks facing Wellington Drive Technologies at this point in time. To help with this, we've discovered 3 warning signs (1 is concerning!) that you ought to be aware of before buying any shares in Wellington Drive Technologies.

Our examination of Wellington Drive Technologies 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 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. 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 that insiders are buying 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.