Broadly speaking, profitable businesses are less risky than 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 Top Education Group (HKG:1752).
While Top Education Group was able to generate revenue of AU$28.3m in the last twelve months, we think its profit result of AU$4.27m 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, 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. Today, we’ll discuss Top Education Group’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 Top Education Group.
Examining Cashflow Against Top Education Group’s Earnings
In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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. The ratio shows us how much a company’s profit exceeds its FCF.
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. 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. That’s because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.
Top Education Group has an accrual ratio of 0.44 for the year to December 2019. That means it didn’t generate anywhere near enough free cash flow to match its profit. Statistically speaking, that’s a real negative for future earnings. To wit, it produced free cash flow of AU$215k during the period, falling well short of its reported profit of AU$4.27m. Top Education Group’s free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits.
Our Take On Top Education Group’s Profit Performance
As we have made quite clear, we’re a bit worried that Top Education Group didn’t back up the last year’s profit with free cashflow. As a result, we think it may well be the case that Top Education Group’s underlying earnings power is lower than its statutory profit. The good news is that, its earnings per share increased by 58% in the last year. 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. In light of this, if you’d like to do more analysis on the company, it’s vital to be informed of the risks involved. To help with this, we’ve discovered 3 warning signs (2 are a bit unpleasant!) that you ought to be aware of before buying any shares in Top Education Group.
This note has only looked at a single factor that sheds light on the nature of Top Education Group’s 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. 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. Thank you for reading.