We Believe Royale Home Holdings' (HKG:1198) Earnings Are A Poor Guide For Its Profitability

Even though Royale Home Holdings Limited (HKG:1198) posted strong earnings recently, the stock hasn't reacted in a large way. We looked deeper into the numbers and found that shareholders might be concerned with some underlying weaknesses.

See our latest analysis for Royale Home Holdings

Examining Cashflow Against Royale Home Holdings' Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Royale Home Holdings has an accrual ratio of 0.22 for the year to December 2020. Unfortunately, that means its free cash flow fell significantly short of its reported profits. To wit, it produced free cash flow of HK$122m during the period, falling well short of its reported profit of HK$714.8m. Royale Home Holdings' free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio. One positive for Royale Home Holdings shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. As a result, some shareholders may be looking for stronger cash conversion in the current year.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Royale Home Holdings.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by HK$1.1b, in the last year, probably goes some way to explain why its accrual ratio was so weak. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's as you'd expect, given these boosts are described as 'unusual'. Royale Home Holdings had a rather significant contribution from unusual items relative to its profit to December 2020. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Royale Home Holdings' Profit Performance

Summing up, Royale Home Holdings received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Royale Home Holdings' profits probably give an overly generous impression of its sustainable level of profitability. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For example, Royale Home Holdings has 3 warning signs (and 1 which is a bit unpleasant) we think you should know about.

Our examination of Royale Home Holdings has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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. 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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