Here's Why We Don't Think Key Alliance Group Berhad's (KLSE:KGROUP) Statutory Earnings Reflect Its Underlying Earnings Potential

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. 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 Key Alliance Group Berhad's (KLSE:KGROUP) statutory profits are a good guide to its underlying earnings.

While Key Alliance Group Berhad was able to generate revenue of RM42.1m in the last twelve months, we think its profit result of RM27.5m was more important. The chart below shows that revenue has improved over the last three years, and, even better, the company has moved from unprofitable to profitable.

Check out our latest analysis for Key Alliance Group Berhad

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. Therefore, today we'll take a look at Key Alliance Group Berhad's cashflow, share issues and unusual items with a view to better understanding the nature of its statutory earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Key Alliance Group Berhad.

A Closer Look At Key Alliance Group Berhad's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to September 2020, Key Alliance Group Berhad had an accrual ratio of 0.43. 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 RM15m despite its profit of RM27.5m, mentioned above. It's worth noting that Key Alliance Group Berhad generated positive FCF of RM1.3m a year ago, so at least they've done it in the past. Having said that, there is more to consider. We must also consider the impact of unusual items on statutory profit (and thus the accrual ratio), as well as note the ramifications of the company issuing new shares. One positive for Key Alliance Group 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. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. Key Alliance Group Berhad expanded the number of shares on issue by 89% over the last year. Therefore, each share now receives a smaller portion of profit. To talk about net income, without noticing earnings per share, is to be distracted by the big numbers while ignoring the smaller numbers that talk to per share value. Check out Key Alliance Group Berhad's historical EPS growth by clicking on this link.

A Look At The Impact Of Key Alliance Group Berhad's Dilution on Its Earnings Per Share (EPS).

Key Alliance Group Berhad was losing money three years ago. Zooming in to the last year, we still can't talk about growth rates coherently, since it made a loss last year. But mathematics aside, it is always good to see when a formerly unprofitable business come good (though we accept profit would have been higher if dilution had not been required). Therefore, one can observe that the dilution is having a fairly profound effect on shareholder returns.

In the long term, if Key Alliance Group Berhad's 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 that reason, you could say that EPS is more important that net income in the long run, assuming the goal is to assess whether a company's share price might grow.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by RM35m, in the last year, probably goes some way to explain why its accrual ratio was so weak. 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. And that's as you'd expect, given these boosts are described as 'unusual'. We can see that Key Alliance Group Berhad's positive unusual items were quite significant relative to its profit in the year 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 Key Alliance Group Berhad's Profit Performance

Key Alliance Group Berhad didn't back up its earnings with free cashflow, but this isn't too surprising given profits were inflated by unusual items. The dilution means the results are weaker when viewed from a per-share perspective. On reflection, the above-mentioned factors give us the strong impression that Key Alliance Group Berhad'sunderlying earnings power is not as good as it might seem, based on the statutory profit numbers. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Our analysis shows 4 warning signs for Key Alliance Group Berhad (2 shouldn't be ignored!) and we strongly recommend you look at them before investing.

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. 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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