We Think Kedge Construction's (TPE:2546) Statutory Profit Might Understate Its Earnings Potential

Broadly speaking, profitable businesses are less risky than unprofitable ones. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. This article will consider whether Kedge Construction's (TPE:2546) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Kedge Construction made a profit of NT$479.4m on revenue of NT$13.4b. In the chart below, you can see that its profit and revenue have both grown over the last three years.

See our latest analysis for Kedge Construction

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. As a result, we think it's well worth considering what Kedge Construction'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 Kedge Construction.

Zooming In On Kedge Construction's 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). 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. 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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to September 2020, Kedge Construction recorded an accrual ratio of -2.10. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of NT$1.1b in the last year, which was a lot more than its statutory profit of NT$479.4m. Kedge Construction's free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons.

Our Take On Kedge Construction's Profit Performance

Happily for shareholders, Kedge Construction produced plenty of free cash flow to back up its statutory profit numbers. Because of this, we think Kedge Construction'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 have grown at an extremely impressive rate over the last three years. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example, we've discovered 1 warning sign that you should run your eye over to get a better picture of Kedge Construction.

This note has only looked at a single factor that sheds light on the nature of Kedge Construction's profit. 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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