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Soft earnings didn't appear to concern Karat Packaging Inc.'s (NASDAQ:KRT) shareholders over the last week. Our analysis suggests that while the profits are soft, the foundations of the business are strong.
Check out our latest analysis for Karat Packaging
A Closer Look At Karat Packaging'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. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.
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. 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 September 2024, Karat Packaging recorded an accrual ratio of -0.11. Therefore, its statutory earnings were quite a lot less than its free cashflow. To wit, it produced free cash flow of US$46m during the period, dwarfing its reported profit of US$28.3m. Karat Packaging did see its free cash flow drop year on year, which is less than ideal, like a Simpson's episode without Groundskeeper Willie.
That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.
Our Take On Karat Packaging's Profit Performance
Karat Packaging's accrual ratio is solid, and indicates strong free cash flow, as we discussed, above. Based on this observation, we consider it likely that Karat Packaging's statutory profit actually understates its earnings potential! And on top of that, its earnings per share have grown at 52% per year over the last three years. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So while earnings quality is important, it's equally important to consider the risks facing Karat Packaging at this point in time. For example - Karat Packaging has 1 warning sign we think you should be aware of.