W5 Solutions' (STO:W5) Strong Earnings Are Of Good Quality

W5 Solutions AB (publ)'s (STO:W5) earnings announcement last week was disappointing for investors, despite the decent profit numbers. Our analysis says that investors should be optimistic, as the strong profit is built on solid foundations.

See our latest analysis for W5 Solutions

A Closer Look At W5 Solutions' 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). 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.

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".

For the year to December 2021, W5 Solutions had an accrual ratio of -0.20. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of kr17m, well over the kr13.4m it reported in profit. W5 Solutions shareholders are no doubt pleased that free cash flow improved over the last twelve months.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of W5 Solutions.

Our Take On W5 Solutions' Profit Performance

Happily for shareholders, W5 Solutions produced plenty of free cash flow to back up its statutory profit numbers. Because of this, we think W5 Solutions' underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! And on top of that, its earnings per share have grown at an extremely impressive rate over the last year. 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. If you'd like to know more about W5 Solutions as a business, it's important to be aware of any risks it's facing. While conducting our analysis, we found that W5 Solutions has 2 warning signs and it would be unwise to ignore them.

This note has only looked at a single factor that sheds light on the nature of W5 Solutions' profit. 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. 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. 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.