We're Not So Sure You Should Rely on HongGuang Lighting Holdings's (HKG:6908) Statutory Earnings

As a general rule, we think profitable companies are less risky than companies that lose money. That said, the current statutory profit is not always a good guide to a company's underlying profitability. This article will consider whether HongGuang Lighting Holdings' (HKG:6908) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months HongGuang Lighting Holdings made a profit of CN¥14.1m on revenue of CN¥196.4m. In the chart below, you can see that its profit and revenue have both grown over the last three years, albeit not in the last year.

View our latest analysis for HongGuang Lighting 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. Today, we'll discuss HongGuang Lighting Holdings' free cashflow relative to its earnings, and consider what that tells us about the company. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of HongGuang Lighting Holdings.

A Closer Look At HongGuang Lighting 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

HongGuang Lighting Holdings has an accrual ratio of 0.48 for the year to June 2020. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Over the last year it actually had negative free cash flow of CN¥53m, in contrast to the aforementioned profit of CN¥14.1m. It's worth noting that HongGuang Lighting Holdings generated positive FCF of CN¥34m a year ago, so at least they've done it in the past. One positive for HongGuang Lighting Holdings shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Our Take On HongGuang Lighting Holdings' Profit Performance

As we discussed above, we think HongGuang Lighting Holdings' earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that HongGuang Lighting Holdings' statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. Nonetheless, it's still worth noting that its earnings per share have grown at 5.9% over the last three years. 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. If you want to do dive deeper into HongGuang Lighting Holdings, you'd also look into what risks it is currently facing. To that end, you should learn about the 2 warning signs we've spotted with HongGuang Lighting Holdings (including 1 which can't be ignored).

Today we've zoomed in on a single data point to better understand the nature of HongGuang Lighting 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. 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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