Here's Why Wong's Kong King International (Holdings)'s (HKG:532) Statutory Earnings Are Arguably Too Conservative

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. This article will consider whether Wong's Kong King International (Holdings)'s (HKG:532) statutory profits are a good guide to its underlying earnings.

We like the fact that Wong's Kong King International (Holdings) made a profit of HK$24.7m on its revenue of HK$4.78b, 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 Wong's Kong King International (Holdings)

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. As a result, we think it's well worth considering what Wong's Kong King International (Holdings)'s cashflow (when compared to its earnings) can tell us about the nature of its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Wong's Kong King International (Holdings).

Zooming In On Wong's Kong King International (Holdings)'s Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to June 2020, Wong's Kong King International (Holdings) recorded an accrual ratio of -0.30. 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 HK$572m, well over the HK$24.7m it reported in profit. Notably, Wong's Kong King International (Holdings) had negative free cash flow last year, so the HK$572m it produced this year was a welcome improvement.

Our Take On Wong's Kong King International (Holdings)'s Profit Performance

As we discussed above, Wong's Kong King International (Holdings)'s accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Because of this, we think Wong's Kong King International (Holdings)'s underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! On the other hand, its EPS actually shrunk in the last twelve months. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So while earnings quality is important, it's equally important to consider the risks facing Wong's Kong King International (Holdings) at this point in time. At Simply Wall St, we found 2 warning signs for Wong's Kong King International (Holdings) and we think they deserve your attention.

This note has only looked at a single factor that sheds light on the nature of Wong's Kong King International (Holdings)'s 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. 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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