Lion Posim Berhad's (KLSE:LIONPSIM) stock performed strongly after the recent earnings report. Despite this, we feel that there are some reasons to be cautious with these earnings.
Zooming In On Lion Posim Berhad'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. 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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".
Lion Posim Berhad has an accrual ratio of 0.39 for the year to December 2020. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. In the last twelve months it actually had negative free cash flow, with an outflow of RM29m despite its profit of RM167.0m, mentioned above. We also note that Lion Posim Berhad's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of RM29m. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.
Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Lion Posim Berhad.
How Do Unusual Items Influence Profit?
The fact that the company had unusual items boosting profit by RM135m, in the last year, probably goes some way to explain why its accrual ratio was so weak. 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. We can see that Lion Posim Berhad's positive unusual items were quite significant relative to its profit in the year to December 2020. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.
Our Take On Lion Posim Berhad's Profit Performance
Lion Posim Berhad had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at Lion Posim Berhad's statutory profits might make it look better than it really is on an underlying level. So while earnings quality is important, it's equally important to consider the risks facing Lion Posim Berhad at this point in time. For instance, we've identified 3 warning signs for Lion Posim Berhad (1 is a bit concerning) you should be familiar with.
In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. But there are plenty of other ways to inform your opinion of a company. Some people consider a high return on equity to be a good sign of a quality business. 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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