We Think Eli Lilly's (NYSE:LLY) Profit Is Only A Baseline For What They Can Achieve

The subdued stock price reaction suggests that Eli Lilly and Company's (NYSE:LLY) strong earnings didn't offer any surprises. Our analysis suggests that investors might be missing some promising details.

Check out our latest analysis for Eli Lilly

Examining Cashflow Against Eli Lilly's 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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 it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to December 2024, Eli Lilly recorded an accrual ratio of 0.25. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. In fact, it had free cash flow of US$1.0b in the last year, which was a lot less than its statutory profit of US$10.6b. Given that Eli Lilly had negative free cash flow in the prior corresponding period, the trailing twelve month resul of US$1.0b would seem to be a step in the right direction. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

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.

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) Eli Lilly saw its profit reduced by unusual items worth US$4.2b. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect Eli Lilly to produce a higher profit next year, all else being equal.

Our Take On Eli Lilly's Profit Performance

Eli Lilly saw unusual items weigh on its profit, which should have made it easier to show high cash conversion, which it did not do, according to its accrual ratio. Based on these factors, it's hard to tell if Eli Lilly's profits are a reasonable reflection of its underlying profitability. So while earnings quality is important, it's equally important to consider the risks facing Eli Lilly at this point in time. To that end, you should learn about the 2 warning signs we've spotted with Eli Lilly (including 1 which is potentially serious).

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 with significant insider holdings 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.