We're Not So Sure You Should Rely on Taizhou Water Group's (HKG:1542) Statutory Earnings

As a general rule, we think profitable companies are less risky than companies that lose money. That said, the current statutory profit is not always a good guide to a company's underlying profitability. In this article, we'll look at how useful this year's statutory profit is, when analysing Taizhou Water Group (HKG:1542).

We like the fact that Taizhou Water Group made a profit of CN¥89.8m on its revenue of CN¥470.8m, in the last year. In the chart below, you can see that its profit and revenue have both grown over the last three years, albeit not in the last year.

View our latest analysis for Taizhou Water Group

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 Taizhou Water Group'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 Taizhou Water Group.

Zooming In On Taizhou Water Group's 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.

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.

Taizhou Water Group has an accrual ratio of 0.29 for the year to June 2020. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Over the last year it actually had negative free cash flow of CN¥480m, in contrast to the aforementioned profit of CN¥89.8m. We also note that Taizhou Water Group's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥480m.

Our Take On Taizhou Water Group's Profit Performance

Taizhou Water Group didn't convert much of its profit to free cash flow in the last year, which some investors may consider rather suboptimal. Therefore, it seems possible to us that Taizhou Water Group's true underlying earnings power is actually less than its statutory profit. But on the bright side, its earnings per share have grown at an extremely impressive rate over the last three years. 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 Taizhou Water Group, you'd also look into what risks it is currently facing. For example, we've found that Taizhou Water Group has 5 warning signs (2 don't sit too well with us!) that deserve your attention before going any further with your analysis.

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