Does Microlink Solutions Berhad's (KLSE:MICROLN) Statutory Profit Adequately Reflect Its Underlying Profit?

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. That said, the current statutory profit is not always a good guide to a company's underlying profitability. In this article, we'll look at how useful this year's statutory profit is, when analysing Microlink Solutions Berhad (KLSE:MICROLN).

While Microlink Solutions Berhad was able to generate revenue of RM209.1m in the last twelve months, we think its profit result of RM13.0m was more important.

View our latest analysis for Microlink Solutions 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'll today take a look at how dilution and cashflow shape our understanding of Microlink Solutions Berhad's earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Microlink Solutions Berhad.

A Closer Look At Microlink Solutions 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. 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.

Microlink Solutions Berhad has an accrual ratio of -0.55 for the year to September 2020. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. In fact, it had free cash flow of RM30m in the last year, which was a lot more than its statutory profit of RM13.0m. Microlink Solutions Berhad shareholders are no doubt pleased that free cash flow improved over the last twelve months. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. Microlink Solutions Berhad expanded the number of shares on issue by 44% over the last year. As a result, its net income is now split between a greater number of shares. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. You can see a chart of Microlink Solutions Berhad's EPS by clicking here.

How Is Dilution Impacting Microlink Solutions Berhad's Earnings Per Share? (EPS)

Unfortunately, we don't have any visibility into its profits three years back, because we lack the data. On the bright side, in the last twelve months it grew profit by 110%. On the other hand, earnings per share are only up 94% over the same period. So you can see that the dilution has had a fairly significant impact on shareholders.

In the long term, earnings per share growth should beget share price growth. So it will certainly be a positive for shareholders if Microlink Solutions Berhad can grow EPS persistently. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. 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.

Our Take On Microlink Solutions Berhad's Profit Performance

In conclusion, Microlink Solutions Berhad has strong cashflow relative to earnings, which indicates good quality earnings, but the dilution means its earnings per share growth is weaker than its profit growth. Given the contrasting considerations, we don't have a strong view as to whether Microlink Solutions Berhad's profits are an apt reflection of its underlying potential for profit. So while earnings quality is important, it's equally important to consider the risks facing Microlink Solutions Berhad at this point in time. In terms of investment risks, we've identified 1 warning sign with Microlink Solutions Berhad, and understanding it should be part of your investment process.

Our examination of Microlink Solutions 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. 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. 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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