Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. This article will consider whether International Business Machines' (NYSE:IBM) statutory profits are a good guide to its underlying earnings.
We like the fact that International Business Machines made a profit of US$5.50b on its revenue of US$73.6b, in the last year. Below, you can see that both its revenue and its profit have fallen over the last three years.
Not all profits are equal, and we can learn more about the nature of a company's past profitability by diving deeper into the financial statements. Thus, we will today look at International Business Machines' cashflow relative to its earnings, and consider how a tax benefit has impacted its statutory profit. 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.
Zooming In On International Business Machines' 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 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".
For the year to December 2020, International Business Machines had an accrual ratio of -0.13. That indicates that its free cash flow was a fair bit more than its statutory profit. Indeed, in the last twelve months it reported free cash flow of US$15b, well over the US$5.50b it reported in profit. International Business Machines shareholders are no doubt pleased that free cash flow improved over the last twelve months. Importantly, we note an unusual tax situation, which we discuss below, has impacted the accruals ratio.
An Unusual Tax Situation
Moving on from the accrual ratio, we note that International Business Machines profited from a tax benefit which contributed US$864m to profit. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! We're sure the company was pleased with its tax benefit. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth. So while we think it's great to receive a tax benefit, it does tend to imply an increased risk that the statutory profit overstates the sustainable earnings power of the business.
Our Take On International Business Machines' Profit Performance
While International Business Machines' accrual ratio stands testament to its strong cashflow, and indicates good quality earnings, the fact that it received a tax benefit suggests that this year's profit may not be a great guide to its sustainable profit run-rate. Considering the aforementioned, we think that International Business Machines' profits are probably a reasonable reflection of its underlying profitability; although we'd be confident in that conclusion if we saw a cleaner set of results. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For example - International Business Machines has 3 warning signs we think you should be aware of.
Our examination of International Business Machines has focussed on certain factors that can make its earnings look better than they are. 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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