Should You Rely On City Service's (WSE:CTS) Earnings Growth?

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. 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. This article will consider whether City Service's (WSE:CTS) statutory profits are a good guide to its underlying earnings.

While City Service was able to generate revenue of €167.0m in the last twelve months, we think its profit result of €4.86m was more important. Interestingly, even though its revenue has been flat over the last few years, its profit has actually increased, as you can see, below.

See our latest analysis for City Service

Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. As a result, today we're going to take a closer look at City Service's cashflow, and unusual items, with a view to understanding what these might tell us about its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of City Service.

Examining Cashflow Against City Service'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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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. 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. 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 2020, City Service had an accrual ratio of -0.13. That indicates that its free cash flow was a fair bit more than its statutory profit. In fact, it had free cash flow of €14m in the last year, which was a lot more than its statutory profit of €4.86m. City Service shareholders are no doubt pleased that free cash flow improved over the last twelve months. 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.

How Do Unusual Items Influence Profit?

City Service's profit was reduced by unusual items worth €955k in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. Assuming those unusual expenses don't come up again, we'd therefore expect City Service to produce a higher profit next year, all else being equal.

Our Take On City Service's Profit Performance

Considering both City Service's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Looking at all these factors, we'd say that City Service's underlying earnings power is at least as good as the statutory numbers would make it seem. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For example, City Service has 4 warning signs (and 1 which is significant) we think you should know about.

After our examination into the nature of City Service's profit, we've come away optimistic for the company. But there is always more to discover if you are capable of focussing your mind on minutiae. 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 that insiders are buying.

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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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