Should You Use Golden Faith Group Holdings's (HKG:2863) Statutory Earnings To Analyse It?

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. 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 Golden Faith Group Holdings (HKG:2863).

While Golden Faith Group Holdings was able to generate revenue of HK$252.8m in the last twelve months, we think its profit result of HK$23.2m was more important. The chart below shows how profit has actually increased over the last three years, even while revenue has declined.

Check out our latest analysis for Golden Faith Group 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. So this article aims to better understand Golden Faith Group Holdings' underlying earnings power by taking a look at how dilution, and unusual items are impacting it, and considering how well those paper profits are being converted into cash flow. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Golden Faith Group Holdings.

A Closer Look At Golden Faith Group Holdings' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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".

For the year to September 2020, Golden Faith Group Holdings had an accrual ratio of -0.76. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of HK$74m during the period, dwarfing its reported profit of HK$23.2m. Golden Faith Group Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that, there is more to consider. We must also consider the impact of unusual items on statutory profit (and thus the accrual ratio), as well as note the ramifications of the company issuing new shares.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Golden Faith Group Holdings issued 18% more new shares over the last year. As a result, its net income is now split between a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. You can see a chart of Golden Faith Group Holdings' EPS by clicking here.

A Look At The Impact Of Golden Faith Group Holdings' Dilution on Its Earnings Per Share (EPS).

As you can see above, Golden Faith Group Holdings has been growing its net income over the last few years, with an annualized gain of 3.5% over three years. But on the other hand, earnings per share actually fell by 19% per year. And over the last 12 months, the company grew its profit by 5.7%. On the other hand, earnings per share are only up 2.2% in that time. So you can see that the dilution has had a bit of an impact on shareholders. Therefore, the dilution is having a noteworthy influence on shareholder returns. And so, you can see quite clearly that dilution is influencing shareholder earnings.

In the long term, earnings per share growth should beget share price growth. So Golden Faith Group Holdings shareholders will want to see that EPS figure continue to increase. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For that reason, you could say that EPS is more important that net income in the long run, assuming the goal is to assess whether a company's share price might grow.

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Golden Faith Group Holdings' profit was boosted by unusual items worth HK$4.0m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And, after all, that's exactly what the accounting terminology implies. If Golden Faith Group Holdings doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Golden Faith Group Holdings' Profit Performance

Summing up, Golden Faith Group Holdings' accrual ratio suggests that its statutory earnings are well matched by cash flow while its unusual items boosted the profit in a way that might not be repeated. Further, the dilution means profits are now split more ways. Based on these factors, we think it's very unlikely that Golden Faith Group Holdings' statutory profits make it seem much weaker than it is. If you'd like to know more about Golden Faith Group Holdings as a business, it's important to be aware of any risks it's facing. For example, we've found that Golden Faith Group Holdings has 4 warning signs (1 makes us a bit uncomfortable!) that deserve your attention before going any further with your analysis.

Our examination of Golden Faith Group Holdings has focussed on certain factors that can make its earnings look better than they are. 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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