Here's Why Maxnerva Technology Services' (HKG:1037) Statutory Earnings Are Arguably Too Conservative

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. 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. This article will consider whether Maxnerva Technology Services' (HKG:1037) statutory profits are a good guide to its underlying earnings.

We like the fact that Maxnerva Technology Services made a profit of CN¥15.3m on its revenue of CN¥535.9m, in the last year. The chart below shows how it has grown revenue over the last three years, but that profit has declined.

See our latest analysis for Maxnerva Technology Services

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. So today we'll look at what Maxnerva Technology Services' 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 Maxnerva Technology Services.

Examining Cashflow Against Maxnerva Technology Services' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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.

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. While having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to June 2020, Maxnerva Technology Services had an accrual ratio of -0.48. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of CN¥87m, well over the CN¥15.3m it reported in profit. Maxnerva Technology Services' free cash flow improved over the last year, which is generally good to see.

Our Take On Maxnerva Technology Services' Profit Performance

As we discussed above, Maxnerva Technology Services' accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Based on this observation, we consider it possible that Maxnerva Technology Services' statutory profit actually understates its earnings potential! On the other hand, its EPS actually shrunk in the last twelve months. 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. At Simply Wall St, we found 3 warning signs for Maxnerva Technology Services and we think they deserve your attention.

This note has only looked at a single factor that sheds light on the nature of Maxnerva Technology Services' profit. 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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