We Wouldn't Rely On Sevenet's (WSE:SEV) Statutory Earnings As A Guide

As a general rule, we think profitable companies are less risky than companies that lose money. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. In this article, we'll look at how useful this year's statutory profit is, when analysing Sevenet (WSE:SEV).

We like the fact that Sevenet made a profit of zł5.00m on its revenue of zł122.1m, in the last year. The good news is that the company managed to grow its revenue over the last three years, and also move from loss-making to profitable.

View our latest analysis for Sevenet

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. So today we'll look at what Sevenet's cashflow and unusual items tell us about the quality of its earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Sevenet.

A Closer Look At Sevenet'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. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. The ratio shows us how much a company's profit exceeds its FCF.

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. 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 September 2020, Sevenet recorded an accrual ratio of 0.66. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. To wit, it produced free cash flow of zł2.4m during the period, falling well short of its reported profit of zł5.00m. Sevenet's free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part. The good news for shareholders is that Sevenet's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Sevenet's profit was boosted by unusual items worth zł348k in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. 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'. 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 Sevenet's Profit Performance

Summing up, Sevenet received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Sevenet's profits probably give an overly generous impression of its sustainable level of profitability. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For example, Sevenet has 5 warning signs (and 3 which make us uncomfortable) we think you should know about.

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. 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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