Is There More To The Story Than Image Sensing Systems's (NASDAQ:ISNS) Earnings Growth?

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. In this article, we'll look at how useful this year's statutory profit is, when analysing Image Sensing Systems (NASDAQ:ISNS).

It's good to see that over the last twelve months Image Sensing Systems made a profit of US$6.08m on revenue of US$13.7m. In the chart below, you can see that its profit and revenue have both grown over the last three years, although its revenue has slipped in the last twelve months.

View our latest analysis for Image Sensing Systems

Importantly, statutory profits are not always the best tool for understanding a company's true earnings power, so it's well worth examining profits in a little more detail. So today we'll look at what Image Sensing Systems' cashflow tells us about its earnings, as well as examining how the receipt of a tax benefit has impacted its statutory earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Image Sensing Systems.

Examining Cashflow Against Image Sensing Systems' Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. 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".

Image Sensing Systems has an accrual ratio of 0.45 for the year to June 2020. Ergo, its free cash flow is significantly weaker than its profit. As a general rule, that bodes poorly for future profitability. Indeed, in the last twelve months it reported free cash flow of US$1.7m, which is significantly less than its profit of US$6.08m. We note, however, that Image Sensing Systems grew its free cash flow over the last year. However, as we will discuss below, we can see that the company's accrual ratio has been impacted by its tax situation. This would partially explain why the accrual ratio was so poor.

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that Image Sensing Systems received a tax benefit of US$5.1m. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. Of course, prima facie it's great to receive a 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 Image Sensing Systems' Profit Performance

This year, Image Sensing Systems couldn't match its profit with cashflow. If the tax benefit is not repeated, then profit would drop next year, all else being equal. On reflection, the above-mentioned factors give us the strong impression that Image Sensing Systems'underlying earnings power is not as good as it might seem, based on the statutory profit numbers. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. To that end, you should learn about the 2 warning signs we've spotted with Image Sensing Systems (including 1 which makes us a bit uncomfortable).

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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. 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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