Here's Why We Don't Think Stella Holdings Berhad's (KLSE:STELLA) Statutory Earnings Reflect Its Underlying Earnings Potential

As a general rule, we think profitable companies are less risky than companies that lose money. 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 Stella Holdings Berhad's (KLSE:STELLA) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Stella Holdings Berhad made a profit of RM4.13m on revenue of RM38.8m. Even though revenue is down over the last three years, you can see in the chart below that the company has moved from loss-making to profitable.

View our latest analysis for Stella Holdings Berhad

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 Stella Holdings Berhad's cashflow and unusual items tell 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 Stella Holdings Berhad.

A Closer Look At Stella Holdings Berhad's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Stella Holdings Berhad has an accrual ratio of 0.63 for the year to September 2020. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of RM24m, in contrast to the aforementioned profit of RM4.13m. We saw that FCF was RM2.7m a year ago though, so Stella Holdings Berhad has at least been able to generate positive FCF in the past. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio. One positive for Stella Holdings Berhad shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. As a result, some shareholders may be looking for stronger cash conversion in the current year.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Stella Holdings Berhad's profit was boosted by unusual items worth RM958k in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. If Stella Holdings Berhad 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 Stella Holdings Berhad's Profit Performance

Stella Holdings Berhad had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue Stella Holdings Berhad's profits probably give an overly generous impression of its sustainable level of profitability. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. To that end, you should learn about the 3 warning signs we've spotted with Stella Holdings Berhad (including 1 which doesn't sit too well with us).

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 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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