We Think Citi Trends's (NASDAQ:CTRN) Statutory Profit Might Understate Its Earnings Potential

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. That said, the current statutory profit is not always a good guide to a company's underlying profitability. This article will consider whether Citi Trends' (NASDAQ:CTRN) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Citi Trends made a profit of US$15.4m on revenue of US$742.4m. Interestingly, even though its revenue has been flat over the last few years, its profit has actually increased, as you can see, below.

See our latest analysis for Citi Trends

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. Therefore, we think it's worth taking a closer look at Citi Trends' cashflow, as well as examining the impact that unusual items have had on its reported profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Citi Trends.

Zooming In On Citi Trends' 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. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Citi Trends has an accrual ratio of -0.49 for the year to October 2020. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of US$62m during the period, dwarfing its reported profit of US$15.4m. Citi Trends' free cash flow improved over the last year, which is generally good to see. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

The Impact Of Unusual Items On Profit

Citi Trends' profit was reduced by unusual items worth US$2.9m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. 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. If Citi Trends doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On Citi Trends' Profit Performance

In conclusion, both Citi Trends' accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Based on these factors, we think Citi Trends' underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Case in point: We've spotted 3 warning signs for Citi Trends you should be mindful of and 1 of these bad boys is a bit unpleasant.

Our examination of Citi Trends has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. But there is always more to discover if you are capable of focussing your mind on minutiae. 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. 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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