Here's Why We Don't Think A-Rank Berhad's (KLSE:ARANK) Statutory Earnings Reflect Its Underlying Earnings Potential

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. Today we'll focus on whether this year's statutory profits are a good guide to understanding A-Rank Berhad (KLSE:ARANK).

We like the fact that A-Rank Berhad made a profit of RM7.24m on its revenue of RM417.4m, 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.

Check out our latest analysis for A-Rank Berhad

Not all profits are equal, and we can learn more about the nature of a company's past profitability by diving deeper into the financial statements. As a result, we think it's well worth considering what A-Rank Berhad's cashflow (when compared to its earnings) can tell us about the nature of its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of A-Rank Berhad.

A Closer Look At A-Rank 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.

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".

For the year to October 2020, A-Rank Berhad had an accrual ratio of 0.35. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. In the last twelve months it actually had negative free cash flow, with an outflow of RM63m despite its profit of RM7.24m, mentioned above. We saw that FCF was RM22m a year ago though, so A-Rank Berhad has at least been able to generate positive FCF in the past. One positive for A-Rank 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.

Our Take On A-Rank Berhad's Profit Performance

As we discussed above, we think A-Rank Berhad's earnings were not supported by free cash flow, which might concern some investors. As a result, we think it may well be the case that A-Rank Berhad's underlying earnings power is lower than its statutory profit. In further bad news, its earnings per share decreased in the last year. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. When we did our research, we found 5 warning signs for A-Rank Berhad (3 are a bit concerning!) that we believe deserve your full attention.

Today we've zoomed in on a single data point to better understand the nature of A-Rank Berhad's profit. But there are plenty of other ways to inform your opinion of a company. 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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