Urban Outfitters' (NASDAQ:URBN) Conservative Accounting Might Explain Soft Earnings

Urban Outfitters, Inc.'s (NASDAQ:URBN) recent soft profit numbers didn't appear to worry shareholders. However, we think the company is showing some signs that things are more promising than they seem.

See our latest analysis for Urban Outfitters

Zooming In On Urban Outfitters' 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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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.

Over the twelve months to January 2021, Urban Outfitters recorded an accrual ratio of -0.13. Therefore, its statutory earnings were quite a lot less than its free cashflow. In fact, it had free cash flow of US$127m in the last year, which was a lot more than its statutory profit of US$1.24m. Urban Outfitters' free cash flow improved over the last year, which is generally good to see. Having said that, there is more to the story. 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?

Urban Outfitters' profit was reduced by unusual items worth US$15m 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. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. 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. In the twelve months to January 2021, Urban Outfitters had a big unusual items expense. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.

Our Take On Urban Outfitters' Profit Performance

Considering both Urban Outfitters' accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. After considering all this, we reckon Urban Outfitters' statutory profit probably understates its earnings potential! If you'd like to know more about Urban Outfitters as a business, it's important to be aware of any risks it's facing. Every company has risks, and we've spotted 3 warning signs for Urban Outfitters you should know about.

Our examination of Urban Outfitters has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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. 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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