NZ Automotive Investments Limited's (NZSE:NZA) recent weak earnings report didn't cause a big stock movement. We think that investors are worried about some weaknesses underlying the earnings.
Examining Cashflow Against NZ Automotive Investments' 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. 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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.
For the year to September 2021, NZ Automotive Investments had an accrual ratio of 0.35. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Over the last year it actually had negative free cash flow of NZ$2.1m, in contrast to the aforementioned profit of NZ$2.73m. We saw that FCF was NZ$4.2m a year ago though, so NZ Automotive Investments has at least been able to generate positive FCF in the past. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio. One positive for NZ Automotive Investments shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. As a result, some shareholders may be looking for stronger cash conversion in the current year.
Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of NZ Automotive Investments.
The Impact Of Unusual Items On Profit
Given the accrual ratio, it's not overly surprising that NZ Automotive Investments' profit was boosted by unusual items worth NZ$599k in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).
Our Take On NZ Automotive Investments' Profit Performance
NZ Automotive Investments had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue NZ Automotive Investments' profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing NZ Automotive Investments at this point in time. Case in point: We've spotted 8 warning signs for NZ Automotive Investments you should be mindful of and 2 of them are potentially serious.
In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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. 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.