Here's Why King Fook Holdings's (HKG:280) Statutory Earnings Are Arguably Too Conservative

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. Today we'll focus on whether this year's statutory profits are a good guide to understanding King Fook Holdings (HKG:280).

While King Fook Holdings was able to generate revenue of HK$575.2m in the last twelve months, we think its profit result of HK$18.6m was more important. The good news is that the company managed to grow its revenue over the last three years, and also move from loss-making to profitable.

Check out our latest analysis for King Fook Holdings

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. So today we'll look at what King Fook Holdings' cashflow tells 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 King Fook Holdings.

Examining Cashflow Against King Fook 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. 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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

King Fook Holdings has an accrual ratio of -0.24 for the year to September 2020. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of HK$125m, well over the HK$18.6m it reported in profit. King Fook Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months.

Our Take On King Fook Holdings' Profit Performance

Happily for shareholders, King Fook Holdings produced plenty of free cash flow to back up its statutory profit numbers. Because of this, we think King Fook Holdings' underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! Furthermore, it has done a great job growing EPS over the last year. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. If you want to do dive deeper into King Fook Holdings, you'd also look into what risks it is currently facing. Every company has risks, and we've spotted 1 warning sign for King Fook Holdings you should know about.

This note has only looked at a single factor that sheds light on the nature of King Fook 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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