We're Not Counting On Sprocomm Intelligence (HKG:1401) To Sustain Its Statutory Profitability

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. That said, the current statutory profit is not always a good guide to a company's underlying profitability. This article will consider whether Sprocomm Intelligence's (HKG:1401) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Sprocomm Intelligence made a profit of CN¥38.1m on revenue of CN¥2.85b. We can see in the depiction below that while it did manage to grow its revenue over the last three years, profit has been pretty flat.

See our latest analysis for Sprocomm Intelligence

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 Sprocomm Intelligence's cashflow and unusual items tell 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 Sprocomm Intelligence.

Zooming In On Sprocomm Intelligence's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. 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".

Over the twelve months to June 2020, Sprocomm Intelligence recorded an accrual ratio of 0.27. Unfortunately, that means its free cash flow fell significantly short of its reported profits. To wit, it produced free cash flow of CN¥8.8m during the period, falling well short of its reported profit of CN¥38.1m. Sprocomm Intelligence shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part. The good news for shareholders is that Sprocomm Intelligence's 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. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Sprocomm Intelligence's profit was boosted by unusual items worth CN¥51m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And that's as you'd expect, given these boosts are described as 'unusual'. We can see that Sprocomm Intelligence's positive unusual items were quite significant relative to its profit in the year to June 2020. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Sprocomm Intelligence's Profit Performance

Summing up, Sprocomm Intelligence received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For the reasons mentioned above, we think that a perfunctory glance at Sprocomm Intelligence's statutory profits might make it look better than it really is on an underlying level. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. Our analysis shows 4 warning signs for Sprocomm Intelligence (2 can't be ignored!) and we strongly recommend you look at them before investing.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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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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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