Should You Rely On Chien Kuo Construction's (TPE:5515) Earnings Growth?

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. Today we'll focus on whether this year's statutory profits are a good guide to understanding Chien Kuo Construction (TPE:5515).

We like the fact that Chien Kuo Construction made a profit of NT$409.5m on its revenue of NT$8.03b, in the last year. Happily, it has grown both its profit and revenue over the last three years, as you can see in the chart below.

View our latest analysis for Chien Kuo Construction

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. Therefore, we think it's worth taking a closer look at Chien Kuo Construction's cashflow, as well as examining the impact that unusual items have had on its reported profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Chien Kuo Construction.

Zooming In On Chien Kuo Construction'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. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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.

Over the twelve months to September 2020, Chien Kuo Construction recorded an accrual ratio of -0.35. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of NT$1.1b during the period, dwarfing its reported profit of NT$409.5m. Chien Kuo Construction's free cash flow improved over the last year, which is generally good to see. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

How Do Unusual Items Influence Profit?

Surprisingly, given Chien Kuo Construction's accrual ratio implied strong cash conversion, its paper profit was actually boosted by NT$63m in unusual items. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And that's as you'd expect, given these boosts are described as 'unusual'. If Chien Kuo Construction 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 Chien Kuo Construction's Profit Performance

Chien Kuo Construction's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Based on these factors, we think that Chien Kuo Construction's profits are a reasonably conservative guide to its underlying profitability. If you want to do dive deeper into Chien Kuo Construction, you'd also look into what risks it is currently facing. For example - Chien Kuo Construction has 1 warning sign we think you should be aware of.

Our examination of Chien Kuo Construction 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. 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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