Is There More To The Story Than Contel Technology's (HKG:1912) Earnings Growth?

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. That said, the current statutory profit is not always a good guide to a company's underlying profitability. Today we'll focus on whether this year's statutory profits are a good guide to understanding Contel Technology (HKG:1912).

While Contel Technology was able to generate revenue of US$127.7m in the last twelve months, we think its profit result of US$3.76m was more important. One positive is that it has grown both its profit and its revenue, over the last few years.

View our latest analysis for Contel Technology

Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. Therefore, we think it's worth taking a closer look at Contel Technology's cashflow, as well as examining the impact that unusual items have had on its reported profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Contel Technology.

Zooming In On Contel Technology's 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 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Contel Technology has an accrual ratio of 0.56 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. In the last twelve months it actually had negative free cash flow, with an outflow of US$6.9m despite its profit of US$3.76m, mentioned above. It's worth noting that Contel Technology generated positive FCF of US$4.0m a year ago, so at least they've done it 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. The good news for shareholders is that Contel Technology'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

Unfortunately (in the short term) Contel Technology saw its profit reduced by unusual items worth US$2.7m. 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. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect Contel Technology to produce a higher profit next year, all else being equal.

Our Take On Contel Technology's Profit Performance

In conclusion, Contel Technology's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Having considered these factors, we don't think Contel Technology's statutory profits give an overly harsh view of the business. 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 3 warning signs for Contel Technology (1 is potentially serious!) 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, as a guide to a business. 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. 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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