Here's Why REDtone Digital Berhad's (KLSE:REDTONE) Statutory Earnings Are Arguably Too Conservative

Broadly speaking, profitable businesses are less risky than unprofitable ones. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. In this article, we'll look at how useful this year's statutory profit is, when analysing REDtone Digital Berhad (KLSE:REDTONE).

It's good to see that over the last twelve months REDtone Digital Berhad made a profit of RM4.17m on revenue of RM157.2m. The good news is that the company managed to grow its revenue over the last three years, and also move from loss-making to profitable.

View our latest analysis for REDtone Digital 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 REDtone Digital 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 REDtone Digital Berhad.

Examining Cashflow Against REDtone Digital Berhad's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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.

REDtone Digital Berhad has an accrual ratio of -0.91 for the year to September 2020. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of RM70m in the last year, which was a lot more than its statutory profit of RM4.17m. REDtone Digital Berhad shareholders are no doubt pleased that free cash flow improved over the last twelve months. 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?

REDtone Digital Berhad's profit was reduced by unusual items worth RM25m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. In the twelve months to September 2020, REDtone Digital Berhad had a big unusual items expense. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.

Our Take On REDtone Digital Berhad's Profit Performance

Considering both REDtone Digital Berhad's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Based on these factors, we think REDtone Digital Berhad's underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. You'd be interested to know, that we found 5 warning signs for REDtone Digital Berhad and you'll want to know about them.

Our examination of REDtone Digital Berhad has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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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