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The market shrugged off Nortech Systems Incorporated's (NASDAQ:NSYS) solid earnings report. We think that investors might be worried about some concerning underlying factors.
View our latest analysis for Nortech Systems
Examining Cashflow Against Nortech Systems' 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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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. 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.
Over the twelve months to September 2024, Nortech Systems recorded an accrual ratio of 0.23. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. In the last twelve months it actually had negative free cash flow, with an outflow of US$4.6m despite its profit of US$4.54m, mentioned above. We saw that FCF was US$4.8m a year ago though, so Nortech Systems has at least been able to generate positive FCF in the past. 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. The good news for shareholders is that Nortech Systems' 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 Nortech Systems.
An Unusual Tax Situation
In addition to the notable accrual ratio, we can see that Nortech Systems received a tax benefit of US$1.5m. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! We're sure the company was pleased with its tax benefit. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal. So while we think it's great to receive a tax benefit, it does tend to imply an increased risk that the statutory profit overstates the sustainable earnings power of the business.