We're Not Counting On International Holdings Company PJSC (ADX:IHC) To Sustain Its Statutory Profitability

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. That said, the current statutory profit is not always a good guide to a company's underlying profitability. Today we'll focus on whether this year's statutory profits are a good guide to understanding International Holdings Company PJSC (ADX:IHC).

We like the fact that International Holdings Company PJSC made a profit of د.إ2.19b on its revenue of د.إ5.25b, in the last year. We know some investors love those high revenue growth stocks, but we do like to look at profit, even if it is, perhaps, a bit old fashioned.

See our latest analysis for International Holdings Company PJSC

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. So today we'll look at what International Holdings Company PJSC'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 International Holdings Company PJSC.

Zooming In On International Holdings Company PJSC'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. The ratio shows us how much a company's profit exceeds its FCF.

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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to September 2020, International Holdings Company PJSC recorded an accrual ratio of 0.24. Unfortunately, that means its free cash flow fell significantly short of its reported profits. In fact, it had free cash flow of د.إ1.5b in the last year, which was a lot less than its statutory profit of د.إ2.19b. Notably, International Holdings Company PJSC had negative free cash flow last year, so the د.إ1.5b it produced this year was a welcome improvement. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by د.إ297m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. If International Holdings Company PJSC doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On International Holdings Company PJSC's Profit Performance

International Holdings Company PJSC had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue International Holdings Company PJSC's profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into International Holdings Company PJSC, you'd also look into what risks it is currently facing. While conducting our analysis, we found that International Holdings Company PJSC has 1 warning sign and it would be unwise to ignore it.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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.
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