Yahoo Finance Investors Can Find Comfort In Select Water Solutions' (NYSE:WTTR) Earnings Quality
Shareholders appeared unconcerned with Select Water Solutions, Inc.'s (NYSE:WTTR) lackluster earnings report last week. Our analysis suggests that while the profits are soft, the foundations of the business are strong.
See our latest analysis for Select Water Solutions
A Closer Look At Select Water Solutions' Earnings
In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.
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 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".
Select Water Solutions has an accrual ratio of -0.11 for the year to June 2024. That indicates that its free cash flow was a fair bit more than its statutory profit. Indeed, in the last twelve months it reported free cash flow of US$165m, well over the US$58.4m it reported in profit. Select Water Solutions shareholders are no doubt pleased that free cash flow improved over the last twelve months. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio.
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.
How Do Unusual Items Influence Profit?
Select Water Solutions' profit was reduced by unusual items worth US$9.9m 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. 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. Assuming those unusual expenses don't come up again, we'd therefore expect Select Water Solutions to produce a higher profit next year, all else being equal.
An Unusual Tax Situation
Moving on from the accrual ratio, we note that Select Water Solutions profited from a tax benefit which contributed US$55m to profit. 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, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth.
Our Take On Select Water Solutions' Profit Performance
Summing up, Select Water Solutions' accrual ratio and its unusual items suggest that its statutory earnings were temporarily depressed, while its tax benefit is having the opposite effect. Considering the aforementioned, we think that Select Water Solutions' 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. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. At Simply Wall St, we found 2 warning signs for Select Water Solutions and we think they deserve your attention.
Our examination of Select Water Solutions has focussed on certain factors that can make its earnings look better than they are. But there are plenty of other ways to inform your opinion of a company. 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks with high insider ownership.
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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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com
