Here's Why Edensoft Holdings's (HKG:1147) 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. In this article, we'll look at how useful this year's statutory profit is, when analysing Edensoft Holdings (HKG:1147).

It's good to see that over the last twelve months Edensoft Holdings made a profit of CN¥20.0m on revenue of CN¥650.5m. One positive is that it has grown both its profit and its revenue, over the last few years, though not in the last twelve months.

Check out our latest analysis for Edensoft 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 Edensoft 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 Edensoft Holdings.

Examining Cashflow Against Edensoft 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. The ratio shows us how much a company's profit exceeds its FCF.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Edensoft Holdings has an accrual ratio of -1.58 for the year to June 2020. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. In fact, it had free cash flow of CN¥82m in the last year, which was a lot more than its statutory profit of CN¥20.0m. Edensoft Holdings' free cash flow improved over the last year, which is generally good to see.

Our Take On Edensoft Holdings' Profit Performance

As we discussed above, Edensoft Holdings' accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Because of this, we think Edensoft Holdings' underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. If you want to do dive deeper into Edensoft Holdings, you'd also look into what risks it is currently facing. Case in point: We've spotted 1 warning sign for Edensoft Holdings you should be aware of.

This note has only looked at a single factor that sheds light on the nature of Edensoft Holdings' profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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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