Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. That said, the current statutory profit is not always a good guide to a company's underlying profitability. This article will consider whether Skillful Craftsman Education Technology's (NASDAQ:EDTK) statutory profits are a good guide to its underlying earnings.
While Skillful Craftsman Education Technology was able to generate revenue of US$28.6m in the last twelve months, we think its profit result of US$9.98m was more important.
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. So today we'll look at what Skillful Craftsman Education Technology's cashflow tells us about the quality of its earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Skillful Craftsman Education Technology.
Examining Cashflow Against Skillful Craftsman Education Technology's 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. 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.
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 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".
Over the twelve months to March 2020, Skillful Craftsman Education Technology recorded an accrual ratio of 0.72. That means it didn't generate anywhere near enough free cash flow to match its profit. As a general rule, that bodes poorly for future profitability. To wit, it produced free cash flow of US$1.1m during the period, falling well short of its reported profit of US$9.98m. Skillful Craftsman Education Technology's free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits.
Our Take On Skillful Craftsman Education Technology's Profit Performance
As we have made quite clear, we're a bit worried that Skillful Craftsman Education Technology didn't back up the last year's profit with free cashflow. For this reason, we think that Skillful Craftsman Education Technology's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But at least holders can take some solace from the 15% EPS growth in 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. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Every company has risks, and we've spotted 2 warning signs for Skillful Craftsman Education Technology (of which 1 is a bit concerning!) you should know about.
This note has only looked at a single factor that sheds light on the nature of Skillful Craftsman Education Technology's 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. 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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