Does Organic Tea Cosmetics Holdings's (KOSDAQ:900300) Statutory Profit Adequately Reflect Its Underlying Profit?

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. This article will consider whether Organic Tea Cosmetics Holdings' (KOSDAQ:900300) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Organic Tea Cosmetics Holdings made a profit of ₩12.3b on revenue of ₩305.1b. As you can see in the chart below, its profit has declined over the last three years, even though its revenue has increased.

Check out our latest analysis for Organic Tea Cosmetics Holdings

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 examine what Organic Tea Cosmetics Holdings' cashflow and its expanding share count tell us about the nature of its profits. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Organic Tea Cosmetics Holdings.

Examining Cashflow Against Organic Tea Cosmetics Holdings' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to September 2020, Organic Tea Cosmetics Holdings had an accrual ratio of -0.23. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of ₩54b during the period, dwarfing its reported profit of ₩12.3b. Organic Tea Cosmetics Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. In fact, Organic Tea Cosmetics Holdings increased the number of shares on issue by 13% over the last twelve months by issuing new shares. Therefore, each share now receives a smaller portion of profit. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. You can see a chart of Organic Tea Cosmetics Holdings' EPS by clicking here.

A Look At The Impact Of Organic Tea Cosmetics Holdings' Dilution on Its Earnings Per Share (EPS).

Unfortunately, Organic Tea Cosmetics Holdings' profit is down 68% per year over three years. Even looking at the last year, profit was still down 66%. Sadly, earnings per share fell further, down a full 70% in that time. 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.

In the long term, if Organic Tea Cosmetics Holdings' earnings per share can increase, then the share price should too. 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.

Our Take On Organic Tea Cosmetics Holdings' Profit Performance

In conclusion, Organic Tea Cosmetics Holdings has a strong cashflow relative to earnings, which indicates good quality earnings, but the dilution means its earnings per share are dropping faster than its profit. Considering all the aforementioned, we'd venture that Organic Tea Cosmetics Holdings' profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. So while earnings quality is important, it's equally important to consider the risks facing Organic Tea Cosmetics Holdings at this point in time. Case in point: We've spotted 5 warning signs for Organic Tea Cosmetics Holdings you should be mindful of and 1 of them can't be ignored.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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. 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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