Here's Why HBL Power Systems's (NSE:HBLPOWER) 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. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. In this article, we'll look at how useful this year's statutory profit is, when analysing HBL Power Systems (NSE:HBLPOWER).

It's good to see that over the last twelve months HBL Power Systems made a profit of ₹89.1m on revenue of ₹9.01b. In the last few years both its revenue and its profit have fallen, as you can see in the chart below.

View our latest analysis for HBL Power Systems

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. So today we'll look at what HBL Power Systems' cashflow tells 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 HBL Power Systems.

Examining Cashflow Against HBL Power Systems' 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. The ratio shows us how much a company's profit exceeds its FCF.

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. 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 September 2020, HBL Power Systems recorded an accrual ratio of -0.25. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of ₹2.1b in the last year, which was a lot more than its statutory profit of ₹89.1m. HBL Power Systems' free cash flow improved over the last year, which is generally good to see.

Our Take On HBL Power Systems' Profit Performance

As we discussed above, HBL Power Systems' accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Based on this observation, we consider it possible that HBL Power Systems' statutory profit actually understates its earnings potential! Unfortunately, though, its earnings per share actually fell back over the last year. 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. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For instance, we've identified 5 warning signs for HBL Power Systems (1 doesn't sit too well with us) you should be familiar with.

This note has only looked at a single factor that sheds light on the nature of HBL Power Systems' profit. 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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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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