Broadly speaking, profitable businesses are less risky than unprofitable ones. That said, the current statutory profit is not always a good guide to a company's underlying profitability. In this article, we'll look at how useful this year's statutory profit is, when analysing REM Group (Holdings) (HKG:1750).
While REM Group (Holdings) was able to generate revenue of HK$211.7m in the last twelve months, we think its profit result of HK$11.5m was more important. The chart below shows how it has grown revenue over the last three years, but that profit has declined.
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. So today we'll look at what REM Group (Holdings)'s 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 REM Group (Holdings).
Examining Cashflow Against REM Group (Holdings)'s 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.
As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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".
Over the twelve months to December 2019, REM Group (Holdings) recorded an accrual ratio of 0.28. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Over the last year it actually had negative free cash flow of HK$20m, in contrast to the aforementioned profit of HK$11.5m. We also note that REM Group (Holdings)'s free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of HK$20m.
Our Take On REM Group (Holdings)'s Profit Performance
REM Group (Holdings) didn't convert much of its profit to free cahs flow in the last year, which some investors may consider rather suboptimal. Therefore, it seems possible to us that REM Group (Holdings)'s true underlying earnings power is actually less than its statutory profit. The good news is that its earnings per share increased slightly in the last year. 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 REM Group (Holdings) as a business, it's important to be aware of any risks it's facing. Every company has risks, and we've spotted 4 warning signs for REM Group (Holdings) (of which 2 are a bit concerning!) you should know about.
This note has only looked at a single factor that sheds light on the nature of REM Group (Holdings)'s profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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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