Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. 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 Wai Chi Holdings (HKG:1305).
It's good to see that over the last twelve months Wai Chi Holdings made a profit of HK$32.7m on revenue of HK$1.91b. In the chart below, you can see that its profit and revenue have both grown over the last three years, although its profit has slipped in the last twelve months.
Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. As a result, we think it's well worth considering what Wai Chi 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 Wai Chi Holdings.
Zooming In On Wai Chi Holdings' Earnings
As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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.
That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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. 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, Wai Chi Holdings had an accrual ratio of 0.32. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. Even though it reported a profit of HK$32.7m, a look at free cash flow indicates it actually burnt through HK$248m in the last year. We saw that FCF was HK$100m a year ago though, so Wai Chi Holdings has at least been able to generate positive FCF in the past. The good news for shareholders is that Wai Chi Holdings' accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.
Our Take On Wai Chi Holdings' Profit Performance
Wai Chi Holdings' accrual ratio for the last twelve months signifies cash conversion is less than ideal, which is a negative when it comes to our view of its earnings. Therefore, it seems possible to us that Wai Chi Holdings' true underlying earnings power is actually less than its statutory profit. But the good news is that its EPS growth over the last three years has been very impressive. 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. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For example, Wai Chi Holdings has 4 warning signs (and 2 which make us uncomfortable) we think you should know about.
This note has only looked at a single factor that sheds light on the nature of Wai Chi Holdings' profit. 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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Wai Chi Holdings
Wai Chi Holdings Company Limited, an investment holding company, manufactures and trades in light-emitting diode (LED) backlight and LED lighting products to business corporations and public utilities in the People’s Republic of China, Hong Kong, Taiwan, and internationally.
Excellent balance sheet with solid track record.