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Shareholders appeared unconcerned with Avarga Limited's (SGX:U09) lackluster earnings report last week. Our analysis suggests that while the profits are soft, the foundations of the business are strong.
View our latest analysis for Avarga
Examining Cashflow Against Avarga's 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. 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.
That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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 June 2024, Avarga recorded an accrual ratio of -0.14. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of S$69m during the period, dwarfing its reported profit of S$9.09m. Avarga's free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.
Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Avarga.
How Do Unusual Items Influence Profit?
Avarga's profit was reduced by unusual items worth S$15m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. 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. If Avarga doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.