We Think Ethan Allen Interiors' (NYSE:ETH) Statutory Profit Might Understate Its Earnings Potential

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. Today we'll focus on whether this year's statutory profits are a good guide to understanding Ethan Allen Interiors (NYSE:ETH).

While Ethan Allen Interiors was able to generate revenue of US$571.2m in the last twelve months, we think its profit result of US$13.9m was more important. In the last few years both its revenue and its profit have fallen, as you can see in the chart below.

View our latest analysis for Ethan Allen Interiors

Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. Therefore, we think it's worth taking a closer look at Ethan Allen Interiors' cashflow, as well as examining the impact that unusual items have had on its reported 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.

Zooming In On Ethan Allen Interiors' 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. 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".

Ethan Allen Interiors has an accrual ratio of -0.22 for the year to December 2020. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of US$82m in the last year, which was a lot more than its statutory profit of US$13.9m. Ethan Allen Interiors shareholders are no doubt pleased that free cash flow improved over the last twelve months. 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.

How Do Unusual Items Influence Profit?

Ethan Allen Interiors' profit was reduced by unusual items worth US$10m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. 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. Assuming those unusual expenses don't come up again, we'd therefore expect Ethan Allen Interiors to produce a higher profit next year, all else being equal.

Our Take On Ethan Allen Interiors' Profit Performance

In conclusion, both Ethan Allen Interiors' accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Based on these factors, we think Ethan Allen Interiors' underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! If you'd like to know more about Ethan Allen Interiors as a business, it's important to be aware of any risks it's facing. For example, we've discovered 4 warning signs that you should run your eye over to get a better picture of Ethan Allen Interiors.

Our examination of Ethan Allen Interiors has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. But there are plenty of other ways to inform your opinion of a company. 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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