Broadly speaking, profitable businesses are less risky than 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. Today we'll focus on whether this year's statutory profits are a good guide to understanding NOVATECH (KOSDAQ:285490).
We like the fact that NOVATECH made a profit of ₩14.4b on its revenue of ₩60.9b, in the last year. In the chart below, you can see that its profit and revenue have both grown 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. As a result, today we're going to take a closer look at NOVATECH's cashflow, and unusual items, with a view to understanding what these might tell us about its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of NOVATECH.
A Closer Look At NOVATECH'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 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".
NOVATECH has an accrual ratio of -0.28 for the year to September 2020. 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 ₩19b, well over the ₩14.4b it reported in profit. Given that NOVATECH had negative free cash flow in the prior corresponding period, the trailing twelve month resul of ₩19b would seem to be a step in the right direction. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.
The Impact Of Unusual Items On Profit
Surprisingly, given NOVATECH's accrual ratio implied strong cash conversion, its paper profit was actually boosted by ₩2.1b in unusual items. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And, after all, that's exactly what the accounting terminology implies. If NOVATECH doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.
Our Take On NOVATECH's Profit Performance
In conclusion, NOVATECH's accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Considering all the aforementioned, we'd venture that NOVATECH's profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. If you want to do dive deeper into NOVATECH, you'd also look into what risks it is currently facing. You'd be interested to know, that we found 1 warning sign for NOVATECH and you'll want to know about it.
Our examination of NOVATECH has focussed on certain factors that can make its earnings look better than they are. 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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