Unsurprisingly, Suntech S.A.'s (WSE:SUN) stock price was strong on the back of its healthy earnings report. However, our analysis suggests that shareholders may be missing some factors that indicate the earnings result was not as good as it looked.
Examining Cashflow Against Suntech's Earnings
As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.
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 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.
Suntech has an accrual ratio of 0.52 for the year to December 2021. 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 zł2.9m during the period, falling well short of its reported profit of zł6.10m. Notably, Suntech had negative free cash flow last year, so the zł2.9m it produced this year was a welcome improvement.
Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Suntech.
Our Take On Suntech's Profit Performance
As we have made quite clear, we're a bit worried that Suntech didn't back up the last year's profit with free cashflow. For this reason, we think that Suntech's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But the good news is that its EPS growth over the last three years has been very impressive. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For example, we've found that Suntech has 3 warning signs (1 makes us a bit uncomfortable!) that deserve your attention before going any further with your analysis.
This note has only looked at a single factor that sheds light on the nature of Suntech's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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.
Valuation is complex, but we're helping make it simple.
Find out whether Suntech is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.View the Free Analysis
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.