Here's Why We Think China Ecotek's (TPE:1535) Statutory Earnings Might Be Conservative

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. 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 China Ecotek's (TPE:1535) statutory profits are a good guide to its underlying earnings.

While China Ecotek was able to generate revenue of NT$8.48b in the last twelve months, we think its profit result of NT$170.0m was more important. Interestingly, even though its revenue has been flat over the last few years, its profit has actually increased, as you can see, below.

Check out our latest analysis for China Ecotek

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. As a result, we think it's well worth considering what China Ecotek's cashflow (when compared to its earnings) can tell us about the nature of its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of China Ecotek.

Examining Cashflow Against China Ecotek'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. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to September 2020, China Ecotek had an accrual ratio of -1.01. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of NT$1.5b during the period, dwarfing its reported profit of NT$170.0m. Notably, China Ecotek had negative free cash flow last year, so the NT$1.5b it produced this year was a welcome improvement.

Our Take On China Ecotek's Profit Performance

Happily for shareholders, China Ecotek produced plenty of free cash flow to back up its statutory profit numbers. Because of this, we think China Ecotek's underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! And on top of that, its earnings per share increased by 34% in the 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'd like to know more about China Ecotek as a business, it's important to be aware of any risks it's facing. To that end, you should learn about the 2 warning signs we've spotted with China Ecotek (including 1 which is a bit unpleasant).

Today we've zoomed in on a single data point to better understand the nature of China Ecotek's profit. 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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