We're Not Counting On VARSAV Game Studios (WSE:VAR) To Sustain Its Statutory Profitability

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. Today we'll focus on whether this year's statutory profits are a good guide to understanding VARSAV Game Studios (WSE:VAR).

While VARSAV Game Studios was able to generate revenue of zł1.61m in the last twelve months, we think its profit result of zł6.36m was more important. The chart below shows that revenue has improved over the last three years, and, even better, the company has moved from unprofitable to profitable.

Check out our latest analysis for VARSAV Game Studios

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 VARSAV Game Studios' 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 VARSAV Game Studios.

A Closer Look At VARSAV Game Studios' 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). 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to September 2020, VARSAV Game Studios recorded an accrual ratio of 2.68. Ergo, its free cash flow is significantly weaker than its profit. As a general rule, that bodes poorly for future profitability. In fact, it had free cash flow of zł111k in the last year, which was a lot less than its statutory profit of zł6.36m. Given that VARSAV Game Studios had negative free cash flow in the prior corresponding period, the trailing twelve month resul of zł111k would seem to be a step in the right direction. 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 VARSAV Game Studios' 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?

The fact that the company had unusual items boosting profit by zł7.3m, in the last year, probably goes some way to explain why its accrual ratio was so weak. 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 analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's as you'd expect, given these boosts are described as 'unusual'. VARSAV Game Studios had a rather significant contribution from unusual items relative to its profit to September 2020. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On VARSAV Game Studios' Profit Performance

VARSAV Game Studios had a weak accrual ratio, but its profit did receive a boost from unusual items. For all the reasons mentioned above, we think that, at a glance, VARSAV Game Studios' statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. If you'd like to know more about VARSAV Game Studios as a business, it's important to be aware of any risks it's facing. To that end, you should learn about the 4 warning signs we've spotted with VARSAV Game Studios (including 2 which are a bit concerning).

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 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. 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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