Here's Why We Think Oriental Watch Holdings's (HKG:398) Statutory Earnings Might Be Conservative

Broadly speaking, profitable businesses are less risky than unprofitable ones. That said, the current statutory profit is not always a good guide to a company's underlying profitability. In this article, we'll look at how useful this year's statutory profit is, when analysing Oriental Watch Holdings (HKG:398).

It's good to see that over the last twelve months Oriental Watch Holdings made a profit of HK$96.7m on revenue of HK$2.54b. The chart below shows how profit has actually increased over the last three years, even while revenue has declined.

View our latest analysis for Oriental Watch 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. Therefore, we think it's worth taking a closer look at Oriental Watch Holdings' cashflow, as well as examining the impact that unusual items have had on its reported 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.

Zooming In On Oriental Watch 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). 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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 September 2020, Oriental Watch Holdings had an accrual ratio of -0.16. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of HK$258m during the period, dwarfing its reported profit of HK$96.7m. Oriental Watch Holdings did see its free cash flow drop year on year, which is less than ideal, like a Simpson's episode without Groundskeeper Willie. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

How Do Unusual Items Influence Profit?

Oriental Watch Holdings' profit was reduced by unusual items worth HK$26m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. 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, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect Oriental Watch Holdings to produce a higher profit next year, all else being equal.

Our Take On Oriental Watch Holdings' Profit Performance

Considering both Oriental Watch Holdings' accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Looking at all these factors, we'd say that Oriental Watch Holdings' underlying earnings power is at least as good as the statutory numbers would make it seem. If you'd like to know more about Oriental Watch Holdings as a business, it's important to be aware of any risks it's facing. Case in point: We've spotted 2 warning signs for Oriental Watch Holdings you should be aware of.

After our examination into the nature of Oriental Watch Holdings' profit, we've come away optimistic for the company. 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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