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. This article will consider whether Harvey Norman Holdings' (ASX:HVN) statutory profits are a good guide to its underlying earnings.
While Harvey Norman Holdings was able to generate revenue of AU$2.29b in the last twelve months, we think its profit result of AU$480.5m was more important. Happily, it has grown both its profit and revenue over the last three years, as you can see in the chart below.
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 Harvey Norman Holdings' cashflow tells us about the quality of its earnings. 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.
Examining Cashflow Against 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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. 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 implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. In fact, it had free cash flow of AU$963m in the last year, which was a lot more than its statutory profit of AU$480.5m. Harvey Norman Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months.
Our Take On Harvey Norman Holdings' Profit Performance
As we discussed above, Harvey Norman Holdings has perfectly satisfactory free cash flow relative to profit. Because of this, we think Harvey Norman Holdings' earnings potential is at least as good as it seems, and maybe even better! And the EPS is up 13% over the last twelve months. 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. Our analysis shows 2 warning signs for Harvey Norman Holdings (1 is concerning!) and we strongly recommend you look at these before investing.
Today we've zoomed in on a single data point to better understand the nature of Harvey Norman Holdings' profit. But there are plenty of other ways to inform your opinion of a company. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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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