Here's Why We Don't Think CPS Technologies's (NASDAQ:CPSH) Statutory Earnings Reflect Its Underlying Earnings Potential

As a general rule, we think profitable companies are less risky than companies that lose money. 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. Today we'll focus on whether this year's statutory profits are a good guide to understanding CPS Technologies (NASDAQ:CPSH).

We like the fact that CPS Technologies made a profit of US$1.48m on its revenue of US$22.2m, in the last year. The chart below shows that revenue has improved over the last three years, and, even better, the company has moved from unprofitable to profitable.

See our latest analysis for CPS Technologies

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. Today, we'll discuss CPS Technologies' free cashflow relative to its earnings, and consider what that tells us about the company. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of CPS Technologies.

A Closer Look At CPS Technologies' 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.

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 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 September 2020, CPS Technologies recorded an accrual ratio of 0.36. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of US$1.48m, a look at free cash flow indicates it actually burnt through US$784k in the last year. It's worth noting that CPS Technologies generated positive FCF of US$858k a year ago, so at least they've done it in the past. One positive for CPS Technologies shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. As a result, some shareholders may be looking for stronger cash conversion in the current year.

Our Take On CPS Technologies' Profit Performance

As we discussed above, we think CPS Technologies' earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that CPS Technologies' statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. The good news is that it earned a profit in the last twelve months, despite its previous loss. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. To help with this, we've discovered 3 warning signs (1 doesn't sit too well with us!) that you ought to be aware of before buying any shares in CPS Technologies.

This note has only looked at a single factor that sheds light on the nature of CPS Technologies' profit. 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. 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. 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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