As a general rule, we think profitable companies are less risky than companies that lose money. 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. Today we’ll focus on whether this year’s statutory profits are a good guide to understanding SH Group (Holdings) (HKG:1637).
While SH Group (Holdings) was able to generate revenue of HK$568.4m in the last twelve months, we think its profit result of HK$26.0m was more important. In the chart below, you can see that its profit and revenue have both grown over the last three years.
Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. Today, we’ll discuss SH Group (Holdings)’s free cashflow relative to its earnings, and consider what that tells us about the company. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of SH Group (Holdings).
Examining Cashflow Against SH Group (Holdings)’s Earnings
As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company’s free cash flow (FCF) matches its profit. 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. You could think of the accrual ratio from cashflow as the ‘non-FCF profit ratio’.
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 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.
Over the twelve months to March 2020, SH Group (Holdings) recorded an accrual ratio of -0.22. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of HK$55m during the period, dwarfing its reported profit of HK$26.0m. Given that SH Group (Holdings) had negative free cash flow in the prior corresponding period, the trailing twelve month resul of HK$55m would seem to be a step in the right direction.
Our Take On SH Group (Holdings)’s Profit Performance
Happily for shareholders, SH Group (Holdings) produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that SH Group (Holdings)’s statutory profit actually understates its earnings potential! Better yet, its EPS are growing strongly, which is nice to see. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company’s potential, but there is plenty more to consider. If you’d like to know more about SH Group (Holdings) as a business, it’s important to be aware of any risks it’s facing. You’d be interested to know, that we found 2 warning signs for SH Group (Holdings) and you’ll want to know about these.
This note has only looked at a single factor that sheds light on the nature of SH Group (Holdings)’s profit. 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. 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 that insiders are buying to be useful.
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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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