We Think That There Are Issues Underlying Sol-Gel Technologies' (NASDAQ:SLGL) Earnings

Despite posting some strong earnings, the market for Sol-Gel Technologies Ltd.'s (NASDAQ:SLGL) stock hasn't moved much. Our analysis suggests that this might be because shareholders have noticed some concerning underlying factors.

View our latest analysis for Sol-Gel Technologies

Examining Cashflow Against Sol-Gel Technologies' 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). 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. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to December 2021, Sol-Gel Technologies had an accrual ratio of 1.70. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of US$7.8m, in contrast to the aforementioned profit of US$3.22m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of US$7.8m, this year, indicates high risk. The good news for shareholders is that Sol-Gel Technologies' 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. As a result, some shareholders may be looking for stronger cash conversion in the current year.

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 Sol-Gel Technologies' Profit Performance

As we discussed above, we think Sol-Gel Technologies' earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that Sol-Gel Technologies' 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. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. In terms of investment risks, we've identified 1 warning sign with Sol-Gel Technologies, and understanding this should be part of your investment process.

Today we've zoomed in on a single data point to better understand the nature of Sol-Gel Technologies' profit. 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. 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.