Broadly speaking, profitable businesses are less risky than unprofitable ones. That said, the current statutory profit is not always a good guide to a company’s underlying profitability. Today we’ll focus on whether this year’s statutory profits are a good guide to understanding Allium Medical Solutions (TLV:ALMD).
It’s good to see that over the last twelve months Allium Medical Solutions made a profit of ₪30.2m on revenue of ₪9.62m. The chart below shows that revenue has improved over the last three years, and, even better, the company has moved from unprofitable to profitable.
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. As a result, today we’re going to take a closer look at Allium Medical Solutions’ cashflow, and unusual items, with a view to understanding what these might tell us about its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Allium Medical Solutions.
A Closer Look At Allium Medical Solutions’ 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. 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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.
Allium Medical Solutions has an accrual ratio of 1.01 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. To wit, it produced free cash flow of ₪1.7m during the period, falling well short of its reported profit of ₪30.2m. Notably, Allium Medical Solutions had negative free cash flow last year, so the ₪1.7m it produced this year was a welcome improvement. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part. One positive for Allium Medical Solutions 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. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.
How Do Unusual Items Influence Profit?
The fact that the company had unusual items boosting profit by ₪41m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can’t deny that higher profits generally leave us optimistic, but we’d prefer it if the profit were to be sustainable. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that’s exactly what the accounting terminology implies. Allium Medical Solutions had a rather significant contribution from unusual items relative to its profit to June 2020. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.
Our Take On Allium Medical Solutions’ Profit Performance
Summing up, Allium Medical Solutions received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. On reflection, the above-mentioned factors give us the strong impression that Allium Medical Solutions’underlying earnings power is not as good as it might seem, based on the statutory profit numbers. So while earnings quality is important, it’s equally important to consider the risks facing Allium Medical Solutions at this point in time. Our analysis shows 4 warning signs for Allium Medical Solutions (1 is a bit concerning!) and we strongly recommend you look at these bad boys before investing.
Our examination of Allium Medical Solutions 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. 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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