Zentiva's (BVB:SCD) Solid Earnings May Rest On Weak Foundations

The recent earnings posted by Zentiva S.A. (BVB:SCD) were solid, but the stock didn't move as much as we expected. We think this is due to investors looking beyond the statutory profits and being concerned with what they see.

See our latest analysis for Zentiva

Examining Cashflow Against Zentiva'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. The ratio shows us how much a company's profit exceeds its FCF.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to March 2021, Zentiva recorded an accrual ratio of 0.26. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. In the last twelve months it actually had negative free cash flow, with an outflow of RON50m despite its profit of RON55.1m, mentioned above. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of RON50m, this year, indicates high risk. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

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

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Zentiva's profit was boosted by unusual items worth RON5.8m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And, after all, that's exactly what the accounting terminology implies. If Zentiva doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Zentiva's Profit Performance

Summing up, Zentiva 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 Zentiva's profits probably give an overly generous impression of its sustainable level of profitability. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example - Zentiva has 1 warning sign we think you should be aware of.

Our examination of Zentiva 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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