We Think Shriro Holdings's (ASX:SHM) Statutory Profit Might Understate Its Earnings Potential

As a general rule, we think profitable companies are less risky than companies that lose money. 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. This article will consider whether Shriro Holdings' (ASX:SHM) statutory profits are a good guide to its underlying earnings.

We like the fact that Shriro Holdings made a profit of AU$8.48m on its revenue of AU$170.7m, in the last year. The chart below shows that both revenue and profit have declined over the last three years.

See our latest analysis for Shriro Holdings

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. As a result, we think it's well worth considering what Shriro Holdings' cashflow (when compared to its earnings) can tell us about the nature of its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Shriro Holdings.

Examining Cashflow Against Shriro Holdings' 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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 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".

Shriro Holdings has an accrual ratio of -0.49 for the year to June 2020. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of AU$28m, well over the AU$8.48m it reported in profit. Shriro Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months.

Our Take On Shriro Holdings' Profit Performance

Happily for shareholders, Shriro Holdings produced plenty of free cash flow to back up its statutory profit numbers. Because of this, we think Shriro Holdings' underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! And on top of that, its earnings per share increased by 22% in the last year. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. 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 that end, you should learn about the 4 warning signs we've spotted with Shriro Holdings (including 1 which is concerning).

Today we've zoomed in on a single data point to better understand the nature of Shriro Holdings' 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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