Are Sino-Entertainment Technology Holdings's (HKG:6933) Statutory Earnings A Good Guide To Its Underlying Profitability?

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 Sino-Entertainment Technology Holdings (HKG:6933).

We like the fact that Sino-Entertainment Technology Holdings made a profit of CN¥58.8m on its revenue of CN¥216.4m, in the last year.

View our latest analysis for Sino-Entertainment Technology 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. So today we'll look at what Sino-Entertainment Technology Holdings' cashflow and unusual items tell us about the quality of its earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Sino-Entertainment Technology Holdings.

Zooming In On Sino-Entertainment Technology 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). 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. 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 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. 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, Sino-Entertainment Technology Holdings had an accrual ratio of 0.49. 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. Indeed, in the last twelve months it reported free cash flow of CN¥17m, which is significantly less than its profit of CN¥58.8m. We note, however, that Sino-Entertainment Technology Holdings grew its free cash flow over the last year. 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.

The Impact Of Unusual Items On Profit

Sino-Entertainment Technology Holdings' profit suffered from unusual items, which reduced profit by CN¥15m in the last twelve months. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. 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 Sino-Entertainment Technology Holdings to produce a higher profit next year, all else being equal.

Our Take On Sino-Entertainment Technology Holdings' Profit Performance

Sino-Entertainment 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. Having considered these factors, we don't think Sino-Entertainment Technology Holdings' statutory profits give an overly harsh view of the business. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For example, Sino-Entertainment Technology Holdings has 3 warning signs (and 1 which is potentially serious) we think you should know about.

Our examination of Sino-Entertainment 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. 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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