Mechanical Technology (NASDAQ:MKTY) Is Posting Healthy Earnings, But It Is Not All Good News

Investors were disappointed with Mechanical Technology, Incorporated's (NASDAQ:MKTY) recent earnings release. We did some analysis and believe that they might be concerned about some weak underlying factors.

View our latest analysis for Mechanical Technology

Zooming In On Mechanical Technology's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. 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. 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 December 2020, Mechanical Technology recorded an accrual ratio of 0.50. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. Indeed, in the last twelve months it reported free cash flow of US$787k, which is significantly less than its profit of US$1.95m. We note, however, that Mechanical Technology 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 certainly have contributed to the weak cash conversion.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Mechanical Technology.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Mechanical Technology profited from a tax benefit which contributed US$392k to profit. This is meaningful because companies usually pay tax rather than receive tax benefits. The receipt of a tax benefit is obviously a good thing, on its own. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal. While we think it's good that the company has booked a tax benefit, it does mean that there's every chance the statutory profit will come in a lot higher than it would be if the income was adjusted for one-off factors.

Our Take On Mechanical Technology's Profit Performance

This year, Mechanical Technology couldn't match its profit with cashflow. On top of that, the unsustainable nature of tax benefits mean that there's a chance profit may be lower next year, certainly in the absence of strong growth. Considering all this we'd argue Mechanical Technology's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Mechanical Technology as a business, it's important to be aware of any risks it's facing. To that end, you should learn about the 4 warning signs we've spotted with Mechanical Technology (including 1 which doesn't sit too well with us).

Our examination of Mechanical Technology has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. But there are plenty of other ways to inform your opinion of a company. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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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