Massimo Group's (NASDAQ:MAMO) earnings announcement last week didn't impress shareholders. While the headline numbers were soft, we believe that investors might be missing some encouraging factors.

Examining Cashflow Against Massimo Group'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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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 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".

For the year to September 2024, Massimo Group had an accrual ratio of 0.20. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Indeed, in the last twelve months it reported free cash flow of US$2.2m, which is significantly less than its profit of US$7.33m. Massimo Group's free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits. 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 Massimo Group'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 Massimo Group.

The Impact Of Unusual Items On Profit

Massimo Group's profit suffered from unusual items, which reduced profit by US$3.5m in the last twelve months. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. If Massimo Group doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On Massimo Group's Profit Performance

In conclusion, Massimo Group's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Considering the aforementioned, we think that Massimo Group's profits are probably a reasonable reflection of its underlying profitability; although we'd be confident in that conclusion if we saw a cleaner set of results. So while earnings quality is important, it's equally important to consider the risks facing Massimo Group at this point in time. Be aware that Massimo Group is showing 2 warning signs in our investment analysis and 1 of those is a bit concerning...

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. But there is always more to discover if you are capable of focussing your mind on minutiae. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.