Perfect Group International Holdings's (HKG:3326) Earnings Are Growing But Is There More To The Story?

As a general rule, we think profitable companies are less risky than companies that lose money. 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 Perfect Group International Holdings (HKG:3326).

While Perfect Group International Holdings was able to generate revenue of HK$746.2m in the last twelve months, we think its profit result of HK$172.5m was more important. In the chart below, you can see that its profit and revenue have both grown over the last three years.

See our latest analysis for Perfect Group International 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. Therefore, we think it's worth taking a closer look at Perfect Group International Holdings' cashflow, as well as examining the impact that unusual items have had on its reported profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Perfect Group International Holdings.

A Closer Look At Perfect Group International 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. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. The ratio shows us how much a company's profit exceeds its FCF.

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. 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, Perfect Group International Holdings had an accrual ratio of 0.36. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. To wit, it produced free cash flow of HK$23m during the period, falling well short of its reported profit of HK$172.5m. Perfect Group International Holdings shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months. 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. The good news for shareholders is that Perfect Group International 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.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Perfect Group International Holdings' profit was boosted by unusual items worth HK$36m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. 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'. If Perfect Group International Holdings doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Perfect Group International Holdings' Profit Performance

Summing up, Perfect Group International 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 Perfect Group International Holdings' profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Perfect Group International Holdings at this point in time. For example, Perfect Group International Holdings has 2 warning signs (and 1 which is a bit concerning) we think you should know about.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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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