It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. In this article, we'll look at how useful this year's statutory profit is, when analysing Home Control International (HKG:1747).
It's good to see that over the last twelve months Home Control International made a profit of US$5.46m on revenue of US$168.4m. The chart below shows that it has grown revenue over the last three years, while profit has remained roughly flat.
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. As a result, we think it's well worth considering what Home Control International's cashflow (when compared to its earnings) can tell us about the nature of its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Home Control International.
Examining Cashflow Against Home Control International's 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 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.
Home Control International has an accrual ratio of -0.22 for the year to June 2020. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of US$11m during the period, dwarfing its reported profit of US$5.46m. Home Control International shareholders are no doubt pleased that free cash flow improved over the last twelve months.
Our Take On Home Control International's Profit Performance
As we discussed above, Home Control International's accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Based on this observation, we consider it possible that Home Control International's statutory profit actually understates its earnings potential! And on top of that, its earnings per share increased by 52% 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. If you want to do dive deeper into Home Control International, you'd also look into what risks it is currently facing. Case in point: We've spotted 4 warning signs for Home Control International you should be mindful of and 1 of these can't be ignored.
Today we've zoomed in on a single data point to better understand the nature of Home Control International's profit. But there are plenty of other ways to inform your opinion of a company. 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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