We Think FSE Services Group's (HKG:331) Statutory Profit Might Understate Its Earnings Potential

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. Today we'll focus on whether this year's statutory profits are a good guide to understanding FSE Services Group (HKG:331).

We like the fact that FSE Services Group made a profit of HK$305.0m on its revenue of HK$4.88b, in the last year. As you can see in the chart below, it has grown its profits over the last three years, despite the fact its revenue has been steady.

See our latest analysis for FSE Services Group

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 FSE Services Group'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 FSE Services Group.

Examining Cashflow Against FSE Services Group'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. 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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

FSE Services Group has an accrual ratio of -0.55 for the year to June 2020. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of HK$450m during the period, dwarfing its reported profit of HK$305.0m. FSE Services Group's free cash flow improved over the last year, which is generally good to see.

Our Take On FSE Services Group's Profit Performance

As we discussed above, FSE Services Group's accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Because of this, we think FSE Services Group's underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! And on top of that, its earnings per share have grown at 35% per year over the last three years. 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 FSE Services Group as a business, it's important to be aware of any risks it's facing. At Simply Wall St, we found 2 warning signs for FSE Services Group and we think they deserve your attention.

This note has only looked at a single factor that sheds light on the nature of FSE Services Group's 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.

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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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