Does SunLink Health Systems' (NYSEMKT:SSY) Statutory Profit Adequately Reflect Its Underlying Profit?

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. This article will consider whether SunLink Health Systems' (NYSEMKT:SSY) statutory profits are a good guide to its underlying earnings.

While SunLink Health Systems was able to generate revenue of US$43.9m in the last twelve months, we think its profit result of US$2.21m was more important. Even though revenue is down 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 SunLink Health Systems

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. So today we'll look at what SunLink Health Systems' cashflow and unusual items tell 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 SunLink Health Systems.

Examining Cashflow Against SunLink Health Systems' 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). 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to December 2020, SunLink Health Systems had an accrual ratio of -0.17. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of US$3.8m during the period, dwarfing its reported profit of US$2.21m. Given that SunLink Health Systems had negative free cash flow in the prior corresponding period, the trailing twelve month resul of US$3.8m would seem to be a step in the right direction. 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

While the accrual ratio might bode well, we also note that SunLink Health Systems' profit was boosted by unusual items worth US$3.5m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And that's as you'd expect, given these boosts are described as 'unusual'. We can see that SunLink Health Systems' positive unusual items were quite significant relative to its profit in the year 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.

Our Take On SunLink Health Systems' Profit Performance

SunLink Health Systems' profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Based on these factors, we think it's very unlikely that SunLink Health Systems' statutory profits make it seem much weaker than it is. So while earnings quality is important, it's equally important to consider the risks facing SunLink Health Systems at this point in time. In terms of investment risks, we've identified 3 warning signs with SunLink Health Systems, and understanding these bad boys should be part of your investment process.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying to be useful.

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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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