We Think StrongLED Lighting Systems (Cayman)'s (GTSM:5281) Statutory Profit Might Understate Its Earnings Potential

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 StrongLED Lighting Systems (Cayman) (GTSM:5281).

While StrongLED Lighting Systems (Cayman) was able to generate revenue of NT$906.4m in the last twelve months, we think its profit result of NT$60.6m was more important.

Check out our latest analysis for StrongLED Lighting Systems (Cayman)

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 StrongLED Lighting Systems (Cayman)'s cashflow tells 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 StrongLED Lighting Systems (Cayman).

A Closer Look At StrongLED Lighting Systems (Cayman)'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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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

StrongLED Lighting Systems (Cayman) has an accrual ratio of -0.51 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. Indeed, in the last twelve months it reported free cash flow of NT$384m, well over the NT$60.6m it reported in profit. StrongLED Lighting Systems (Cayman) did see its free cash flow drop year on year, which is less than ideal, like a Simpson's episode without Groundskeeper Willie.

Our Take On StrongLED Lighting Systems (Cayman)'s Profit Performance

As we discussed above, StrongLED Lighting Systems (Cayman)'s accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Based on this observation, we consider it possible that StrongLED Lighting Systems (Cayman)'s statutory profit actually understates its earnings potential! And one can definitely find a positive in the fact that it made a profit this year, despite losing money last year. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. If you want to do dive deeper into StrongLED Lighting Systems (Cayman), you'd also look into what risks it is currently facing. For example, we've found that StrongLED Lighting Systems (Cayman) has 2 warning signs (1 makes us a bit uncomfortable!) that deserve your attention before going any further with your analysis.

This note has only looked at a single factor that sheds light on the nature of StrongLED Lighting Systems (Cayman)'s profit. 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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