Is There More To The Story Than Harvey Norman Holdings' (ASX:HVN) Earnings Growth?

Broadly speaking, profitable businesses are less risky than unprofitable ones. 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 Harvey Norman Holdings (ASX:HVN).

We like the fact that Harvey Norman Holdings made a profit of AU$480.5m on its revenue of AU$2.29b, in the last year. One positive is that it has grown both its profit and its revenue, over the last few years.

See our latest analysis for Harvey Norman Holdings

Not all profits are equal, and we can learn more about the nature of a company's past profitability by diving deeper into the financial statements. As a result, we think it's well worth considering what Harvey Norman Holdings' cashflow (when compared to its earnings) can tell us about the nature of its statutory profit. That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

Zooming In On Harvey Norman Holdings' 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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".

Harvey Norman Holdings has an accrual ratio of -0.13 for the year to June 2020. That indicates that its free cash flow was a fair bit more than its statutory profit. To wit, it produced free cash flow of AU$963m during the period, dwarfing its reported profit of AU$480.5m. Harvey Norman Holdings' free cash flow improved over the last year, which is generally good to see.

Our Take On Harvey Norman Holdings' Profit Performance

Harvey Norman Holdings' accrual ratio is solid, and indicates strong free cash flow, as we discussed, above. Because of this, we think Harvey Norman Holdings' earnings potential is at least as good as it seems, and maybe even better! And on top of that, its earnings per share increased by 13% 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. If you'd like to know more about Harvey Norman Holdings as a business, it's important to be aware of any risks it's facing. Case in point: We've spotted 2 warning signs for Harvey Norman Holdings you should be mindful of and 1 of these shouldn't be ignored.

This note has only looked at a single factor that sheds light on the nature of Harvey Norman 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. 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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