Broadly speaking, profitable businesses are less risky than unprofitable ones. That said, the current statutory profit is not always a good guide to a company’s underlying profitability. This article will consider whether Crocodile Garments‘s (HKG:122) statutory profits are a good guide to its underlying earnings.
While Crocodile Garments was able to generate revenue of HK$235.3m in the last twelve months, we think its profit result of HK$30.6m was more important. As depicted below, while its revenue may have fallen over the last few years, its profit actually improved.
Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. Therefore, we think it’s worth taking a closer look at Crocodile Garments’s cashflow, as well as examining the impact that unusual items have had on its reported profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Crocodile Garments.
Examining Cashflow Against Crocodile Garments’s 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. 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. 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. That’s because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.
For the year to July 2019, Crocodile Garments had an accrual ratio of -0.10. Therefore, its statutory earnings were quite a lot less than its free cashflow. To wit, it produced free cash flow of HK$264m during the period, dwarfing its reported profit of HK$30.6m. Notably, Crocodile Garments had negative free cash flow last year, so the HK$264m it produced this year was a welcome improvement.
Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part
The Impact Of Unusual Items On Profit
Surprisingly, given Crocodile Garments’s accrual ratio implied strong cash conversion, its paper profit was actually boosted by HK$61m in unusual items. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it’s very common for unusual items to be once-off in nature. Which is hardly suprising, given the name. Crocodile Garments had a rather significant contribution from unusual items relative to its profit to July 2019. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.
Our Take On Crocodile Garments’s Profit Performance
Crocodile Garments’s profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Having considered these factors, we’re tentatively of the view that Crocodile Garments’s statutory profit might overstate its underlying earnings. Just as investors must consider earnings, it is also important to take into account the strength of a company’s balance sheet. You can seeour latest analysis on Crocodile Garments’s balance sheet health here.
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 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 that insiders are buying.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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