Yahoo Finance Investors Can Find Comfort In Southwest Airlines' (NYSE:LUV) Earnings Quality
Shareholders appeared unconcerned with Southwest Airlines Co.'s (NYSE:LUV) lackluster earnings report last week. We did some digging, and we believe the earnings are stronger than they seem.
Check out our latest analysis for Southwest Airlines
A Closer Look At Southwest Airlines' 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. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. This ratio tells us how much of a company's profit is not backed by free cashflow.
As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.
Southwest Airlines has an accrual ratio of 0.30 for the year to June 2024. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. In the last twelve months it actually had negative free cash flow, with an outflow of US$1.7b despite its profit of US$78.0m, mentioned above. We also note that Southwest Airlines' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of US$1.7b. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the 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.
The Impact Of Unusual Items On Profit
Southwest Airlines' profit suffered from unusual items, which reduced profit by US$638m 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, after all, that's exactly what the accounting terminology implies. Southwest Airlines took a rather significant hit from unusual items in the year to June 2024. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.
Our Take On Southwest Airlines' Profit Performance
Southwest Airlines saw unusual items weigh on its profit, which should have made it easier to show high cash conversion, which it did not do, according to its accrual ratio. Based on these factors, we think that Southwest Airlines' profits are a reasonably conservative guide to its underlying profitability. So while earnings quality is important, it's equally important to consider the risks facing Southwest Airlines at this point in time. Every company has risks, and we've spotted 3 warning signs for Southwest Airlines (of which 2 are concerning!) you should know about.
Our examination of Southwest Airlines 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. Some people consider a high return on equity to be a good sign of a quality business. 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
