Why BAE Systems' (LON:BA.) Earnings Are Better Than They Seem
Investors signalled that they were pleased with BAE Systems plc's (LON:BA.) most recent earnings report. According to our analysis of the report, the strong headline profit numbers are supported by strong earnings fundamentals.
A Closer Look At BAE Systems' Earnings
One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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'.
As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.
BAE Systems has an accrual ratio of -0.15 for the year to June 2026. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of UK£4.5b during the period, dwarfing its reported profit of UK£2.11b. BAE Systems shareholders are no doubt pleased that free cash flow improved over the last twelve months.
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.
Our Take On BAE Systems' Profit Performance
As we discussed above, BAE Systems has perfectly satisfactory free cash flow relative to profit. Because of this, we think BAE Systems' earnings potential is at least as good as it seems, and maybe even better! And on top of that, its earnings per share have grown at 11% per year over the last three years. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. Ultimately, this article has formed an opinion based on historical data. However, it can also be great to think about what analysts are forecasting for the future. So feel free to check out our free graph representing analyst forecasts.
Today we've zoomed in on a single data point to better understand the nature of BAE Systems' profit. 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.