Shareholders were pleased with the recent earnings report from Toro Corp. (NASDAQ:TORO). Investors should be cautious however, as there some causes of concern deeper in the numbers.
Zooming In On Toro's Earnings
As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. The ratio shows us how much a company's profit exceeds its FCF.
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. 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. 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 March 2024, Toro recorded an accrual ratio of 1.44. 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$37m, in contrast to the aforementioned profit of US$132.2m. We saw that FCF was US$72m a year ago though, so Toro has at least been able to generate positive FCF in the past. 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. The good news for shareholders is that Toro's 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 Toro.
How Do Unusual Items Influence Profit?
Given the accrual ratio, it's not overly surprising that Toro's profit was boosted by unusual items worth US$119m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. 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. Toro had a rather significant contribution from unusual items relative to its profit to March 2024. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.
Our Take On Toro's Profit Performance
Summing up, Toro received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For all the reasons mentioned above, we think that, at a glance, Toro's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. When we did our research, we found 3 warning signs for Toro (2 are a bit concerning!) that we believe deserve your full attention.
In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks with significant insider holdings to be useful.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.