Are Eternity Technology Holdings's (HKG:1725) Statutory Earnings A Good Guide To Its Underlying Profitability?

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 Eternity Technology Holdings (HKG:1725).

It's good to see that over the last twelve months Eternity Technology Holdings made a profit of CN¥8.11m on revenue of CN¥569.7m. The chart below shows how it has grown revenue over the last three years, but that profit has declined.

View our latest analysis for Eternity Technology Holdings

Importantly, statutory profits are not always the best tool for understanding a company's true earnings power, so it's well worth examining profits in a little more detail. So today we'll look at what Eternity Technology Holdings' 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 Eternity Technology Holdings.

Examining Cashflow Against Eternity Technology Holdings' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to June 2020, Eternity Technology Holdings recorded an accrual ratio of 0.20. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥15m despite its profit of CN¥8.11m, mentioned above. We saw that FCF was CN¥6.4m a year ago though, so Eternity Technology Holdings has at least been able to generate positive FCF in the past. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) Eternity Technology Holdings saw its profit reduced by unusual items worth CN¥4.8m. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. If Eternity Technology Holdings doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On Eternity Technology Holdings' Profit Performance

In conclusion, Eternity Technology Holdings' accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Considering all the aforementioned, we'd venture that Eternity Technology Holdings' profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. 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. Case in point: We've spotted 4 warning signs for Eternity Technology Holdings you should be mindful of and 2 of these are a bit concerning.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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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