Should You Use Hengyuan Refining Company Berhad's (KLSE:HENGYUAN) Statutory Earnings To Analyse It?

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. 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. In this article, we'll look at how useful this year's statutory profit is, when analysing Hengyuan Refining Company Berhad (KLSE:HENGYUAN).

We like the fact that Hengyuan Refining Company Berhad made a profit of RM101.0m on its revenue of RM8.50b, in the last year. In the last few years both its revenue and its profit have fallen, as you can see in the chart below.

See our latest analysis for Hengyuan Refining Company Berhad

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. Therefore, we think it's worth taking a closer look at Hengyuan Refining Company Berhad's cashflow, as well as examining the impact that unusual items have had on its reported profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Hengyuan Refining Company Berhad.

Examining Cashflow Against Hengyuan Refining Company Berhad'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. 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 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. 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, Hengyuan Refining Company Berhad had an accrual ratio of -0.15. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of RM545m in the last year, which was a lot more than its statutory profit of RM101.0m. Notably, Hengyuan Refining Company Berhad had negative free cash flow last year, so the RM545m it produced this year was a welcome improvement. 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.

How Do Unusual Items Influence Profit?

Surprisingly, given Hengyuan Refining Company Berhad's accrual ratio implied strong cash conversion, its paper profit was actually boosted by RM126m 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 that's as you'd expect, given these boosts are described as 'unusual'. Hengyuan Refining Company Berhad had a rather significant contribution from unusual items relative to its profit to September 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 Hengyuan Refining Company Berhad's Profit Performance

In conclusion, Hengyuan Refining Company Berhad's accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Having considered these factors, we don't think Hengyuan Refining Company Berhad's statutory profits give an overly harsh view of the business. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Be aware that Hengyuan Refining Company Berhad is showing 3 warning signs in our investment analysis and 1 of those is concerning...

Our examination of Hengyuan Refining Company Berhad 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. 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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