We Think Gap's (NYSE:GPS) Healthy Earnings Might Be Conservative

Shareholders appeared to be happy with The Gap, Inc.'s (NYSE:GPS) solid earnings report last week. This reaction by the market reaction is understandable when looking at headline profits and we have found some further encouraging factors.

View our latest analysis for Gap

A Closer Look At Gap'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). 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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. 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 February 2024, Gap recorded an accrual ratio of -0.24. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of US$1.1b in the last year, which was a lot more than its statutory profit of US$502.0m. Notably, Gap had negative free cash flow last year, so the US$1.1b it produced this year was a welcome improvement.

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 Gap's Profit Performance

Happily for shareholders, Gap produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that Gap's statutory profit actually understates its earnings potential! And one can definitely find a positive in the fact that it made a profit this year, despite 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. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For example - Gap has 1 warning sign we think you should be aware of.

Today we've zoomed in on a single data point to better understand the nature of Gap's profit. 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 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.