Here's Why We Think Fountain Set (Holdings)'s (HKG:420) Statutory Earnings Might Be Conservative

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. In this article, we'll look at how useful this year's statutory profit is, when analysing Fountain Set (Holdings) (HKG:420).

While Fountain Set (Holdings) was able to generate revenue of HK$5.32b in the last twelve months, we think its profit result of HK$43.3m was more important. In the last few years both its revenue and its profit have fallen, as you can see in the chart below.

Check out our latest analysis for Fountain Set (Holdings)

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. So today we'll look at what Fountain Set (Holdings)'s cashflow and unusual items tell us about the quality of its earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Fountain Set (Holdings).

Examining Cashflow Against Fountain Set (Holdings)'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. 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. 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.

Fountain Set (Holdings) has an accrual ratio of -0.15 for the year to June 2020. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of HK$504m, well over the HK$43.3m it reported in profit. Fountain Set (Holdings)'s year-on-year free cash flow was as flat as two-day-old fizzy drink. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

The Impact Of Unusual Items On Profit

Fountain Set (Holdings)'s profit was reduced by unusual items worth HK$12.5m 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. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. 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 Fountain Set (Holdings) to produce a higher profit next year, all else being equal.

Our Take On Fountain Set (Holdings)'s Profit Performance

Considering both Fountain Set (Holdings)'s accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Based on these factors, we think Fountain Set (Holdings)'s earnings potential is at least as good as it seems, and maybe even better! With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. In terms of investment risks, we've identified 2 warning signs with Fountain Set (Holdings), and understanding these should be part of your investment process.

After our examination into the nature of Fountain Set (Holdings)'s profit, we've come away optimistic for the company. But there is always more to discover if you are capable of focussing your mind on minutiae. 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 that insiders are buying.

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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. 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.
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