Should You Use Prosper Construction Holdings' (HKG:6816) Statutory Earnings To Analyse It?

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. That said, the current statutory profit is not always a good guide to a company's underlying profitability. This article will consider whether Prosper Construction Holdings' (HKG:6816) statutory profits are a good guide to its underlying earnings.

We like the fact that Prosper Construction Holdings made a profit of HK$11.9m on its revenue of HK$838.8m, in the last year. We know some investors love those high revenue growth stocks, but we do like to look at profit, even if it is, perhaps, a bit old fashioned. As you can see in the chart below, its profit has declined over the last three years, even though its revenue has increased.

Check out our latest analysis for Prosper Construction 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 Prosper Construction Holdings' 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 Prosper Construction Holdings.

Examining Cashflow Against Prosper Construction 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. 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.

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. 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 June 2020, Prosper Construction Holdings recorded an accrual ratio of 0.23. 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$95m, in contrast to the aforementioned profit of HK$11.9m. It's worth noting that Prosper Construction Holdings generated positive FCF of HK$48m a year ago, so at least they've done it in the past. The good news for shareholders is that Prosper Construction Holdings' accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

Our Take On Prosper Construction Holdings' Profit Performance

Prosper Construction Holdings didn't convert much of its profit to free cash flow in the last year, which some investors may consider rather suboptimal. Because of this, we think that it may be that Prosper Construction Holdings' statutory profits are better than its underlying earnings power. The good news is that, its earnings per share increased by 76% in the last year. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. So while earnings quality is important, it's equally important to consider the risks facing Prosper Construction Holdings at this point in time. Our analysis shows 6 warning signs for Prosper Construction Holdings (3 shouldn't be ignored!) and we strongly recommend you look at them before investing.

Today we've zoomed in on a single data point to better understand the nature of Prosper Construction Holdings' 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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