Should You Rely On Fire Rock Holdings's (HKG:1909) Earnings Growth?

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. 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 Fire Rock Holdings (HKG:1909).

It's good to see that over the last twelve months Fire Rock Holdings made a profit of CN¥339.5m on revenue of CN¥486.3m. In the chart below, you can see that its profit and revenue have both grown over the last three years.

Check out our latest analysis for Fire Rock 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. As a result, we think it's well worth considering what Fire Rock Holdings' cashflow (when compared to its earnings) can tell us about the nature of its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Fire Rock Holdings.

Examining Cashflow Against Fire Rock Holdings' 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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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 June 2020, Fire Rock Holdings had an accrual ratio of 0.50. That means it didn't generate anywhere near enough free cash flow to match its profit. As a general rule, that bodes poorly for future profitability. In fact, it had free cash flow of CN¥304m in the last year, which was a lot less than its statutory profit of CN¥339.5m. We note, however, that Fire Rock Holdings grew its free cash flow over the last year.

Our Take On Fire Rock Holdings' Profit Performance

As we have made quite clear, we're a bit worried that Fire Rock Holdings didn't back up the last year's profit with free cashflow. For this reason, we think that Fire Rock Holdings' statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But the good news is that its EPS growth over the last three years has been very impressive. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Case in point: We've spotted 2 warning signs for Fire Rock Holdings you should be mindful of and 1 of these can't be ignored.

This note has only looked at a single factor that sheds light on the nature of Fire Rock Holdings' profit. 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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