We Think Etion's (JSE:ETO) Profit Is Only A Baseline For What They Can Achieve

The subdued stock price reaction suggests that Etion Limited's (JSE:ETO) strong earnings didn't offer any surprises. We think that investors have missed some encouraging factors underlying the profit figures.

Check out our latest analysis for Etion

A Closer Look At Etion'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). 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. The ratio shows us how much a company's profit exceeds its FCF.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to September 2021, Etion had an accrual ratio of -0.48. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of R182m, well over the R34.7m it reported in profit. Notably, Etion had negative free cash flow last year, so the R182m it produced this year was a welcome improvement.

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

Our Take On Etion's Profit Performance

As we discussed above, Etion's accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Because of this, we think Etion's underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! And it's also positive that the company showed enough improvement to book a profit this year, after 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. When we did our research, we found 3 warning signs for Etion (1 is concerning!) that we believe deserve your full attention.

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

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.