Beauty Health's (NASDAQ:SKIN) Earnings Are Of Questionable Quality

The Beauty Health Company (NASDAQ:SKIN) just reported some strong earnings, and the market reacted accordingly with a healthy uplift in the share price. We did some analysis and think that investors are missing some details hidden beneath the profit numbers.

View our latest analysis for Beauty Health

Zooming In On Beauty Health's 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. 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. 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 2022, Beauty Health recorded an accrual ratio of 0.72. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Over the last year it actually had negative free cash flow of US$125m, in contrast to the aforementioned profit of US$44.4m. We also note that Beauty Health's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of US$125m. The good news for shareholders is that Beauty Health's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

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.

Our Take On Beauty Health's Profit Performance

As we discussed above, we think Beauty Health's earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that Beauty Health's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. On the bright side, the company showed enough improvement to book a profit this year, after losing money last year. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Every company has risks, and we've spotted 2 warning signs for Beauty Health you should know about.

This note has only looked at a single factor that sheds light on the nature of Beauty Health's profit. But there are plenty of other ways to inform your opinion of a company. 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.