Here's Why We Think Stella International Holdings's (HKG:1836) Statutory Earnings Might Be Conservative

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 Stella International Holdings (HKG:1836).

It's good to see that over the last twelve months Stella International Holdings made a profit of US$51.7m on revenue of US$1.31b. The chart below shows that both revenue and profit have declined over the last three years.

View our latest analysis for Stella International Holdings

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. As a result, today we're going to take a closer look at Stella International Holdings' cashflow, and unusual items, with a view to understanding what these might tell us about its statutory profit. That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

A Closer Look At Stella International 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. 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".

For the year to June 2020, Stella International Holdings had an accrual ratio of -0.13. That indicates that its free cash flow was a fair bit more than its statutory profit. Indeed, in the last twelve months it reported free cash flow of US$171m, well over the US$51.7m it reported in profit. Stella International Holdings' free cash flow improved over the last year, which is generally good to see. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

The Impact Of Unusual Items On Profit

Stella International Holdings' profit was reduced by unusual items worth US$7.6m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. Assuming those unusual expenses don't come up again, we'd therefore expect Stella International Holdings to produce a higher profit next year, all else being equal.

Our Take On Stella International Holdings' Profit Performance

Considering both Stella International Holdings' accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Looking at all these factors, we'd say that Stella International Holdings' underlying earnings power is at least as good as the statutory numbers would make it seem. Ultimately, this article has formed an opinion based on historical data. However, it can also be great to think about what analysts are forecasting for the future. Luckily, you can check out what analysts are forecasting by clicking here.

Our examination of Stella International Holdings has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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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