As a general rule, we think profitable companies are less risky than companies that lose money. 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. This article will consider whether LHT Holdings' (SGX:BEI) statutory profits are a good guide to its underlying earnings.
While LHT Holdings was able to generate revenue of S$36.6m in the last twelve months, we think its profit result of S$4.29m was more important. As depicted below, while its revenue may have fallen over the last few years, its profit actually improved.
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, today we're going to take a closer look at LHT Holdings' cashflow, and unusual items, with a view to understanding what these might tell us about its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of LHT Holdings.
Examining Cashflow Against LHT Holdings' 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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.
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.
Over the twelve months to June 2020, LHT Holdings recorded an accrual ratio of -0.13. Therefore, its statutory earnings were quite a lot less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of S$7.3m, well over the S$4.29m it reported in profit. LHT Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.
The Impact Of Unusual Items On Profit
Surprisingly, given LHT Holdings' accrual ratio implied strong cash conversion, its paper profit was actually boosted by S$1.3m in unusual items. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. LHT Holdings had a rather significant contribution from unusual items relative to its profit to June 2020. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.
Our Take On LHT Holdings' Profit Performance
In conclusion, LHT Holdings' accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Based on these factors, we think it's very unlikely that LHT Holdings' statutory profits make it seem much weaker than it is. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. For example, LHT Holdings has 4 warning signs (and 1 which is a bit concerning) we think you should know about.
In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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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