Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. 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. This article will consider whether Indian Hume Pipe's (NSE:INDIANHUME) statutory profits are a good guide to its underlying earnings.
It's good to see that over the last twelve months Indian Hume Pipe made a profit of ₹373.7m on revenue of ₹12.9b. The chart below shows that both revenue and profit have declined over the last three years.
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 Indian Hume Pipe's 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 Indian Hume Pipe.
Examining Cashflow Against Indian Hume Pipe's Earnings
Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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 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.
For the year to September 2020, Indian Hume Pipe had an accrual ratio of -0.12. That indicates that its free cash flow was a fair bit more than its statutory profit. Indeed, in the last twelve months it reported free cash flow of ₹1.7b, well over the ₹373.7m it reported in profit. Given that Indian Hume Pipe had negative free cash flow in the prior corresponding period, the trailing twelve month resul of ₹1.7b would seem to be a step in the right direction.
Our Take On Indian Hume Pipe's Profit Performance
Indian Hume Pipe's accrual ratio is solid, and indicates strong free cash flow, as we discussed, above. Based on this observation, we consider it likely that Indian Hume Pipe's statutory profit actually understates its earnings potential! On the other hand, its EPS actually shrunk in the last twelve months. 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 Indian Hume Pipe, you'd also look into what risks it is currently facing. For example, we've found that Indian Hume Pipe has 3 warning signs (1 can't be ignored!) 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 Indian Hume Pipe's profit. 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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