Here's Why We Think Fountain Set (Holdings)'s (HKG:420) Statutory Earnings Might Be Conservative

As a general rule, we think profitable companies are less risky than companies that lose money. That said, the current statutory profit is not always a good guide to a company's underlying profitability. Today we'll focus on whether this year's statutory profits are a good guide to understanding Fountain Set (Holdings) (HKG:420).

We like the fact that Fountain Set (Holdings) made a profit of HK$43.3m on its revenue of HK$5.32b, in the last year. Below, you can see that both its revenue and its profit have fallen over the last three years.

Check out our latest analysis for Fountain Set (Holdings)

Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. As a result, today we're going to take a closer look at Fountain Set (Holdings)'s cashflow, and unusual items, with a view to understanding what these might tell us about its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Fountain Set (Holdings).

Examining Cashflow Against Fountain Set (Holdings)'s 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. 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 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Fountain Set (Holdings) has an accrual ratio of -0.15 for the year to June 2020. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of HK$504m during the period, dwarfing its reported profit of HK$43.3m. Fountain Set (Holdings)'s year-on-year free cash flow was as flat as two-day-old fizzy drink. 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 Impact Of Unusual Items On Profit

Fountain Set (Holdings)'s profit was reduced by unusual items worth HK$13m 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. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. 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 Fountain Set (Holdings) to produce a higher profit next year, all else being equal.

Our Take On Fountain Set (Holdings)'s Profit Performance

In conclusion, both Fountain Set (Holdings)'s accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Looking at all these factors, we'd say that Fountain Set (Holdings)'s underlying earnings power is at least as good as the statutory numbers would make it seem. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Case in point: We've spotted 3 warning signs for Fountain Set (Holdings) you should be aware of.

Our examination of Fountain Set (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 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. 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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