Here's Why We Think H&E Equipment Services's (NASDAQ:HEES) Statutory Earnings Might Be Conservative

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. That said, the current statutory profit is not always a good guide to a company's underlying profitability. In this article, we'll look at how useful this year's statutory profit is, when analysing H&E Equipment Services (NASDAQ:HEES).

It's good to see that over the last twelve months H&E Equipment Services made a profit of US$3.87m on revenue of US$1.20b. As you can see in the chart below, its profit has declined over the last three years, even though its revenue has increased.

See our latest analysis for H&E Equipment Services

Importantly, statutory profits are not always the best tool for understanding a company's true earnings power, so it's well worth examining profits in a little more detail. As a result, today we're going to take a closer look at H&E Equipment Services' cashflow, and unusual items, with a view to understanding what these might tell us about its statutory profit. That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

Examining Cashflow Against H&E Equipment Services' 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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to September 2020, H&E Equipment Services had an accrual ratio of -0.22. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. In fact, it had free cash flow of US$313m in the last year, which was a lot more than its statutory profit of US$3.87m. H&E Equipment Services shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

The Impact Of Unusual Items On Profit

H&E Equipment Services' profit was reduced by unusual items worth US$59m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. H&E Equipment Services took a rather significant hit from unusual items in the year to September 2020. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.

Our Take On H&E Equipment Services' Profit Performance

In conclusion, both H&E Equipment Services' accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Based on these factors, we think H&E Equipment Services' underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! So while earnings quality is important, it's equally important to consider the risks facing H&E Equipment Services at this point in time. For instance, we've identified 5 warning signs for H&E Equipment Services (1 is significant) you should be familiar with.

Our examination of H&E Equipment Services has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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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