Are Drewloong Precision's (TPE:4572) Statutory Earnings A Good Reflection Of Its Earnings Potential?

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. 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 Drewloong Precision's (TPE:4572) statutory profits are a good guide to its underlying earnings.

While Drewloong Precision was able to generate revenue of NT$467.9m in the last twelve months, we think its profit result of NT$66.4m was more important. In the last few years both its revenue and its profit have fallen, as you can see in the chart below.

Check out our latest analysis for Drewloong Precision

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 Drewloong Precision'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 Drewloong Precision.

Examining Cashflow Against Drewloong Precision'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). 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. 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, Drewloong Precision recorded an accrual ratio of -0.15. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of NT$192m during the period, dwarfing its reported profit of NT$66.4m. Drewloong Precision's free cash flow improved over the last year, which is generally good to see.

Our Take On Drewloong Precision's Profit Performance

As we discussed above, Drewloong Precision has perfectly satisfactory free cash flow relative to profit. Because of this, we think Drewloong Precision's earnings potential is at least as good as it seems, and maybe even better! Unfortunately, though, its earnings per share actually fell back over the last year. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. If you'd like to know more about Drewloong Precision as a business, it's important to be aware of any risks it's facing. Case in point: We've spotted 3 warning signs for Drewloong Precision you should be aware of.

This note has only looked at a single factor that sheds light on the nature of Drewloong Precision'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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