Why a2 Milk's (NZSE:ATM) Earnings Are Better Than They Seem

The market seemed underwhelmed by the solid earnings posted by The a2 Milk Company Limited (NZSE:ATM) recently. Along with the solid headline numbers, we think that investors have some reasons for optimism.

See our latest analysis for a2 Milk

Examining Cashflow Against a2 Milk'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. This ratio tells us how much of a company's profit is not backed by free cashflow.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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".

For the year to June 2024, a2 Milk had an accrual ratio of -0.18. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of NZ$235m in the last year, which was a lot more than its statutory profit of NZ$167.6m. a2 Milk shareholders are no doubt pleased that free cash flow improved over the last twelve months.

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 a2 Milk's Profit Performance

As we discussed above, a2 Milk's accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Because of this, we think a2 Milk's underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! Better yet, its EPS are growing strongly, which is nice to see. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. While conducting our analysis, we found that a2 Milk has 1 warning sign and it would be unwise to ignore this.

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. 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.