We're Not So Sure You Should Rely on Choice Development's (TPE:9929) Statutory Earnings

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 Choice Development's (TPE:9929) statutory profits are a good guide to its underlying earnings.

While Choice Development was able to generate revenue of NT$886.5m in the last twelve months, we think its profit result of NT$826.0m was more important.

Check out our latest analysis for Choice Development

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, today we're going to take a closer look at Choice Development's cashflow, and unusual items, with a view to understanding what these might tell us about its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Choice Development.

Zooming In On Choice Development'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). 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Choice Development has an accrual ratio of 0.47 for the year to September 2020. Ergo, its free cash flow is significantly weaker than its profit. Statistically speaking, that's a real negative for future earnings. To wit, it produced free cash flow of NT$303m during the period, falling well short of its reported profit of NT$826.0m. At this point we should mention that Choice Development did manage to increase its free cash flow in the last twelve months Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part. The good news for shareholders is that Choice Development's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by NT$1.1b, in the last year, probably goes some way to explain why its accrual ratio was so weak. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. 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, after all, that's exactly what the accounting terminology implies. Choice Development had a rather significant contribution from unusual items relative to its profit to September 2020. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Choice Development's Profit Performance

Summing up, Choice Development received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. On reflection, the above-mentioned factors give us the strong impression that Choice Development'sunderlying earnings power is not as good as it might seem, based on the statutory profit numbers. So while earnings quality is important, it's equally important to consider the risks facing Choice Development at this point in time. Be aware that Choice Development is showing 3 warning signs in our investment analysis and 1 of those is potentially serious...

Our examination of Choice Development has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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. 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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