iDreamSky Technology Holdings's (HKG:1119) Earnings Are Growing But Is There More To The Story?

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. 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 iDreamSky Technology Holdings (HKG:1119).

While iDreamSky Technology Holdings was able to generate revenue of CN¥2.79b in the last twelve months, we think its profit result of CN¥352.2m 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 iDreamSky Technology Holdings

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, today we're going to take a closer look at iDreamSky Technology Holdings's 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.

Examining Cashflow Against iDreamSky Technology Holdings'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). 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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.

iDreamSky Technology Holdings has an accrual ratio of 0.26 for the year to December 2019. Unfortunately, that means its free cash flow fell significantly short of its reported profits. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥646m despite its profit of CN¥352.2m, mentioned above. We also note that iDreamSky Technology Holdings's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥646m. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) iDreamSky Technology Holdings saw its profit reduced by unusual items worth CN¥93m. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect iDreamSky Technology Holdings to produce a higher profit next year, all else being equal.

Our Take On iDreamSky Technology Holdings's Profit Performance

iDreamSky Technology Holdings saw unusual items weigh on its profit, which should have made it easier to show high cash conversion, which it did not do, according to its accrual ratio. Given the contrasting considerations, we don't have a strong view as to whether iDreamSky Technology Holdings's profits are an apt reflection of its underlying potential for profit. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. When we did our research, we found 2 warning signs for iDreamSky Technology Holdings (1 doesn't sit too well with us!) that we believe deserve your full attention.

Our examination of iDreamSky Technology Holdings has focussed on certain factors that can make its earnings look better than they are. 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. Thank you for reading.