Here's Why We Don't Think SIFCO Industries' (NYSEMKT:SIF) Statutory Earnings Reflect Its Underlying Earnings Potential

As a general rule, we think profitable companies are less risky than companies that lose money. 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. In this article, we'll look at how useful this year's statutory profit is, when analysing SIFCO Industries (NYSEMKT:SIF).

We like the fact that SIFCO Industries made a profit of US$13.5m on its revenue of US$112.4m, in the last year. Even though revenue has remained steady over the last three years, you can see in the chart below that the company has moved from loss-making to profitable.

Check out our latest analysis for SIFCO Industries

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. Therefore, we think it's worth taking a closer look at SIFCO Industries' cashflow, as well as examining the impact that a tax benefit and unusual items have had on its reported profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of SIFCO Industries.

Zooming In On SIFCO Industries' 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 it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. 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 December 2020, SIFCO Industries recorded an accrual ratio of 0.30. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. Even though it reported a profit of US$13.5m, a look at free cash flow indicates it actually burnt through US$5.9m in the last year. We also note that SIFCO Industries' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of US$5.9m. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio. One positive for SIFCO Industries shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by US$11m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. SIFCO Industries had a rather significant contribution from unusual items relative to its profit to December 2020. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that SIFCO Industries received a tax benefit of US$1.0m. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! Of course, prima facie it's great to receive a tax benefit. And since it previously lost money, it may well simply indicate the realisation of past tax losses. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth. So while we think it's great to receive a tax benefit, it does tend to imply an increased risk that the statutory profit overstates the sustainable earnings power of the business.

Our Take On SIFCO Industries' Profit Performance

In conclusion, SIFCO Industries' weak accrual ratio suggests its statutory earnings have been inflated by the non-cash tax benefit and the boost it received from unusual items. For all the reasons mentioned above, we think that, at a glance, SIFCO Industries' statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Be aware that SIFCO Industries is showing 4 warning signs in our investment analysis and 2 of those are 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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