We Think That There Are Issues Underlying Sevenet's (WSE:SEV) Earnings

Last week's profit announcement from Sevenet S.A. (WSE:SEV) was underwhelming for investors, despite headline numbers being robust. We did some digging and found some worrying underlying problems.

See our latest analysis for Sevenet

A Closer Look At Sevenet's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to December 2023, Sevenet recorded an accrual ratio of -1.22. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of zł13m in the last year, which was a lot more than its statutory profit of zł4.37m. Sevenet shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio).

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

How Do Unusual Items Influence Profit?

Surprisingly, given Sevenet's accrual ratio implied strong cash conversion, its paper profit was actually boosted by zł157k in unusual items. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And that's as you'd expect, given these boosts are described as 'unusual'. If Sevenet doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that Sevenet received a tax benefit of zł3.4m. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! The receipt of a tax benefit is obviously a good thing, on its own. And given that it lost money last year, it seems possible that the benefit is evidence that it now expects to find value in its past tax losses. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. 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 Sevenet's Profit Performance

Summing up, Sevenet's accrual ratio suggests that its statutory earnings are well matched by free cash flow while its unusual items and tax benefit is boosted profit in a way that may not be sustained. Based on these factors, we think that Sevenet's statutory profits probably make it seem better than it is on an underlying level. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Case in point: We've spotted 4 warning signs for Sevenet you should be mindful of and 2 of these shouldn't be ignored.

Our examination of Sevenet 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. 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.