Should You Use Multi-Chem's (SGX:AWZ) Statutory Earnings To Analyse It?

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. 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 Multi-Chem (SGX:AWZ).

While Multi-Chem was able to generate revenue of S$482.9m in the last twelve months, we think its profit result of S$11.2m was more important. While it managed to grow its revenue over the last three years, its profit has moved in the other direction, as you can see in the chart below.

See our latest analysis for Multi-Chem

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. So today we'll look at what Multi-Chem'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 Multi-Chem.

Examining Cashflow Against Multi-Chem'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. 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.

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 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to June 2020, Multi-Chem had an accrual ratio of -0.18. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of S$22m in the last year, which was a lot more than its statutory profit of S$11.2m. Multi-Chem 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.

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Multi-Chem's profit was boosted by unusual items worth S$1.7m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. 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. If Multi-Chem doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Multi-Chem's Profit Performance

In conclusion, Multi-Chem's accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Considering all the aforementioned, we'd venture that Multi-Chem's profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. You'd be interested to know, that we found 2 warning signs for Multi-Chem and you'll want to know about these.

Our examination of Multi-Chem has focussed on certain factors that can make its earnings look better than they are. But there are plenty of other ways to inform your opinion of a company. Some people consider a high return on equity to be a good sign of a quality business. 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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