Is There More To The Story Than a2 Milk's (NZSE:ATM) Earnings Growth?

Broadly speaking, profitable businesses are less risky than unprofitable ones. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. Today we'll focus on whether this year's statutory profits are a good guide to understanding a2 Milk (NZSE:ATM).

While a2 Milk was able to generate revenue of NZ$1.73b in the last twelve months, we think its profit result of NZ$388.2m was more important. One positive is that it has grown both its profit and its revenue, over the last few years.

View our latest analysis for a2 Milk

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 a2 Milk's free cashflow relative to its earnings, and consider what that tells us about the company. 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.

A Closer Look At a2 Milk's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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 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".

a2 Milk has an accrual ratio of -0.11 for the year to June 2020. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. In fact, it had free cash flow of NZ$420m in the last year, which was a lot more than its statutory profit of NZ$388.2m. a2 Milk shareholders are no doubt pleased that free cash flow improved over the last twelve months.

Our Take On a2 Milk's Profit Performance

As we discussed above, a2 Milk has perfectly satisfactory free cash flow relative to profit. Because of this, we think a2 Milk's earnings potential is at least as good as it seems, and maybe even better! Better yet, its EPS are growing strongly, which is nice to see. 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. So while earnings quality is important, it's equally important to consider the risks facing a2 Milk at this point in time. For example - a2 Milk has 1 warning sign we think you should be aware of.

This note has only looked at a single factor that sheds light on the nature of a2 Milk'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. 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. 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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