Should You Use SH Group (Holdings)'s (HKG:1637) Statutory Earnings To Analyse It?

As a general rule, we think profitable companies are less risky than companies that lose money. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. Today we'll focus on whether this year's statutory profits are a good guide to understanding SH Group (Holdings) (HKG:1637).

While SH Group (Holdings) was able to generate revenue of HK$594.1m in the last twelve months, we think its profit result of HK$28.1m was more important. The chart below shows how it has grown revenue over the last three years, but that profit has declined.

Check out our latest analysis for SH Group (Holdings)

Importantly, statutory profits are not always the best tool for understanding a company's true earnings power, so it's well worth examining profits in a little more detail. Today, we'll discuss SH Group (Holdings)'s free cashflow relative to its earnings, and consider what that tells us about the company. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of SH Group (Holdings).

A Closer Look At SH Group (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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. 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".

Over the twelve months to September 2020, SH Group (Holdings) recorded an accrual ratio of -0.16. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of HK$46m, well over the HK$28.1m it reported in profit. Given that SH Group (Holdings) had negative free cash flow in the prior corresponding period, the trailing twelve month resul of HK$46m would seem to be a step in the right direction.

Our Take On SH Group (Holdings)'s Profit Performance

SH Group (Holdings)'s accrual ratio is solid, and indicates strong free cash flow, as we discussed, above. Based on this observation, we consider it likely that SH Group (Holdings)'s statutory profit actually understates its earnings potential! On the other hand, its EPS actually shrunk in the last twelve months. 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. If you want to do dive deeper into SH Group (Holdings), you'd also look into what risks it is currently facing. For example, we've discovered 2 warning signs that you should run your eye over to get a better picture of SH Group (Holdings).

Today we've zoomed in on a single data point to better understand the nature of SH Group (Holdings)'s profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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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