Are Cape Industries's (KOSDAQ:064820) Statutory Earnings A Good Guide To Its Underlying Profitability?

As a general rule, we think profitable companies are less risky than companies that lose money. 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 Cape Industries (KOSDAQ:064820).

We like the fact that Cape Industries made a profit of ₩10.00b on its revenue of ₩426.9b, in the last year. The chart below shows that revenue has improved over the last three years, and, even better, the company has moved from unprofitable to profitable.

See our latest analysis for Cape Industries

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 Cape Industries' cashflow and unusual items tell us about the quality of its earnings, as well as touching on how its recent share issues are impacting shareholders. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Cape Industries.

A Closer Look At Cape Industries' 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. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to September 2020, Cape Industries recorded an accrual ratio of -0.21. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of ₩77b, well over the ₩10.00b it reported in profit. Notably, Cape Industries had negative free cash flow last year, so the ₩77b it produced this year was a welcome improvement. However, that's not the end of the story. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. Cape Industries expanded the number of shares on issue by 20% over the last year. That means its earnings are split among a greater number of shares. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. Check out Cape Industries' historical EPS growth by clicking on this link.

How Is Dilution Impacting Cape Industries' Earnings Per Share? (EPS)

Three years ago, Cape Industries lost money. On the bright side, in the last twelve months it grew profit by 122%. On the other hand, earnings per share are only up 112% over the same period. So you can see that the dilution has had a bit of an impact on shareholders. Therefore, the dilution is having a noteworthy influence on shareholder returns. And so, you can see quite clearly that dilution is influencing shareholder earnings.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So it will certainly be a positive for shareholders if Cape Industries can grow EPS persistently. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

How Do Unusual Items Influence Profit?

Surprisingly, given Cape Industries' accrual ratio implied strong cash conversion, its paper profit was actually boosted by ₩2.6b in unusual items. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Cape Industries' Profit Performance

In conclusion, Cape Industries' accrual ratio suggests its earnings are well backed by cash but its boost from unusual items is probably not going to be repeated consistently. Meanwhile, the dilution was a negative for shareholders. Having considered these factors, we don't think Cape Industries' statutory profits give an overly harsh view of the business. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. While conducting our analysis, we found that Cape Industries has 3 warning signs and it would be unwise to ignore these.

Our examination of Cape Industries has focussed on certain factors that can make its earnings look better than they are. 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. 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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