The market for Elbit Medical Technologies Ltd’s (TLV:EMTC) stock was strong after it released a healthy earnings report last week. However, we think that shareholders should be cautious as we found some worrying factors underlying the profit.
Examining Cashflow Against Elbit Medical Technologies’ 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. 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. 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. To quote a 2014 paper by Lewellen and Resutek, “firms with higher accruals tend to be less profitable in the future”.
For the year to December 2020, Elbit Medical Technologies had an accrual ratio of 2.83. Statistically speaking, that’s a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of US$674k, in contrast to the aforementioned profit of US$123.0m. We also note that Elbit Medical Technologies’ free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of US$674k. The good news for shareholders is that Elbit Medical Technologies’ accrual ratio was much better last year, so this year’s poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.
Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Elbit Medical Technologies.
Our Take On Elbit Medical Technologies’ Profit Performance
As we have made quite clear, we’re a bit worried that Elbit Medical Technologies didn’t back up the last year’s profit with free cashflow. For this reason, we think that Elbit Medical Technologies’ statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. On the bright side, the company showed enough improvement to book a profit this year, after losing money last year. Of course, we’ve only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. Keep in mind, when it comes to analysing a stock it’s worth noting the risks involved. Our analysis shows 3 warning signs for Elbit Medical Technologies (2 are a bit unpleasant!) and we strongly recommend you look at them before investing.
This note has only looked at a single factor that sheds light on the nature of Elbit Medical Technologies’ 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.
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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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