Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. Today we’ll focus on whether this year’s statutory profits are a good guide to understanding G & M Holdings (HKG:6038).
While G & M Holdings was able to generate revenue of HK$329.9m in the last twelve months, we think its profit result of HK$35.5m was more important. The chart below shows how it has grown revenue over the last three years, but that profit has declined.
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 G & M Holdings’s cashflow tells 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 G & M Holdings.
A Closer Look At G & M Holdings’s Earnings
One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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’.
As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. While it’s not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. To quote a 2014 paper by Lewellen and Resutek, “firms with higher accruals tend to be less profitable in the future”.
For the year to June 2019, G & M Holdings had an accrual ratio of 0.36. That means it didn’t generate anywhere near enough free cash flow to match its profit. As a general rule, that bodes poorly for future profitability. In fact, it had free cash flow of HK$8.1m in the last year, which was a lot less than its statutory profit of HK$35.5m. Notably, G & M Holdings had negative free cash flow last year, so the HK$8.1m it produced this year was a welcome improvement.
This would certainly have contributed to the weak cash conversion.
Our Take On G & M Holdings’s Profit Performance
As we discussed above, we think G & M Holdings’s earnings were not supported by free cash flow, which might concern some investors. As a result, we think it may well be the case that G & M Holdings’s underlying earnings power is lower than its statutory profit. In further bad news, its earnings per share decreased in the last year. 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. While it’s very important to consider the profit and loss statement, you can also learn a lot about a company by looking at its balance sheet. If you want to,you can see our take on G & M Holdings’s balance sheet by clicking here.
Today we’ve zoomed in on a single data point to better understand the nature of G & M 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.
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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