Robust Earnings May Not Tell The Whole Story For U Banquet Group Holding (HKG:1483)

U Banquet Group Holding Limited (HKG:1483) announced strong profits, but the stock was stagnant. Our analysis suggests that this might be because shareholders have noticed some concerning underlying factors.

See our latest analysis for U Banquet Group Holding

Zooming In On U Banquet Group Holding'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. 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.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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.

For the year to December 2020, U Banquet Group Holding had an accrual ratio of -0.20. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of HK$64m in the last year, which was a lot more than its statutory profit of HK$23.9m. U Banquet Group Holding shareholders are no doubt pleased that free cash flow improved over the last twelve months. However, that's not the end of the story. We must also consider the impact of unusual items on statutory profit (and thus the accrual ratio), as well as note the ramifications of the company issuing new shares.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of U Banquet Group Holding.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. In fact, U Banquet Group Holding increased the number of shares on issue by 13% over the last twelve months by issuing new shares. As a result, its net income is now split between a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. Check out U Banquet Group Holding's historical EPS growth by clicking on this link.

A Look At The Impact Of U Banquet Group Holding's Dilution on Its Earnings Per Share (EPS).

Three years ago, U Banquet Group Holding lost money. And even focusing only on the last twelve months, we don't have a meaningful growth rate because it made a loss a year ago, too. What we do know is that while it's great to see a profit over the last twelve months, that profit would have been better, on a per share basis, if the company hadn't needed to issue shares. And so, you can see quite clearly that dilution is influencing shareholder earnings.

If U Banquet Group Holding's EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For that reason, you could say that EPS is more important that net income in the long run, assuming the goal is to assess whether a company's share price might grow.

The Impact Of Unusual Items On Profit

Surprisingly, given U Banquet Group Holding's accrual ratio implied strong cash conversion, its paper profit was actually boosted by HK$11m in unusual items. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And that's as you'd expect, given these boosts are described as 'unusual'. If U Banquet Group Holding 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 U Banquet Group Holding's Profit Performance

In conclusion, U Banquet Group Holding's accrual ratio suggests its earnings are well backed by cash but its boost from unusual items is probably not going to be repeated consistently. Further, the dilution means profits are now split more ways. Having considered these factors, we don't think U Banquet Group Holding's statutory profits give an overly harsh view of the business. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. In terms of investment risks, we've identified 3 warning signs with U Banquet Group Holding, and understanding them should be part of your investment process.

Our examination of U Banquet Group Holding has focussed on certain factors that can make its earnings look better than they are. 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. 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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