Here's Why HPC Holdings's (HKG:1742) Statutory Earnings Are Arguably Too Conservative

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. 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. In this article, we'll look at how useful this year's statutory profit is, when analysing HPC Holdings (HKG:1742).

While HPC Holdings was able to generate revenue of S$193.3m in the last twelve months, we think its profit result of S$9.68m was more important. As you can see below, its profit has actually declined over the last three years, even though its revenue was flat.

See our latest analysis for HPC Holdings

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 HPC Holdings' cashflow tells 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 HPC Holdings.

Examining Cashflow Against HPC 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. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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 April 2020, HPC Holdings recorded an accrual ratio of -0.20. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of S$24m, well over the S$9.68m it reported in profit. Notably, HPC Holdings had negative free cash flow last year, so the S$24m it produced this year was a welcome improvement.

Our Take On HPC Holdings' Profit Performance

As we discussed above, HPC Holdings' accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Based on this observation, we consider it possible that HPC Holdings' 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'd like to know more about HPC Holdings as a business, it's important to be aware of any risks it's facing. Our analysis shows 3 warning signs for HPC Holdings (1 is concerning!) and we strongly recommend you look at these before investing.

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

If you decide to trade HPC Holdings, use the lowest-cost* platform that is rated #1 Overall by Barron’s, Interactive Brokers. Trade stocks, options, futures, forex, bonds and funds on 135 markets, all from a single integrated account. Promoted

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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com.