The market for NZME Limited's (NZSE:NZM) shares didn't move much after it posted weak earnings recently. We did some digging, and we believe the earnings are stronger than they seem.

View our latest analysis for NZME

A Closer Look At NZME's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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".

NZME has an accrual ratio of -0.13 for the year to June 2024. Therefore, its statutory earnings were quite a lot less than its free cashflow. In fact, it had free cash flow of NZ$33m in the last year, which was a lot more than its statutory profit of NZ$12.2m. NZME's free cash flow improved over the last year, which is generally good to see. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

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?

NZME's profit was reduced by unusual items worth NZ$2.7m 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. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. If NZME doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.