I-HWA IndustrialLtd's (TPE:1456) Robust Profit May Be Overstating Its True Earnings Potential

I-HWA Industrial Co.,Ltd (TPE:1456) posted some decent earnings, but shareholders didn't react strongly. Our analysis has found some concerning factors which weaken the profit's foundation.

Check out our latest analysis for I-HWA IndustrialLtd

Zooming In On I-HWA IndustrialLtd'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. 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'.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to December 2020, I-HWA IndustrialLtd had an accrual ratio of 0.27. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Over the last year it actually had negative free cash flow of NT$1.4b, in contrast to the aforementioned profit of NT$68.1m. It's worth noting that I-HWA IndustrialLtd generated positive FCF of NT$53m a year ago, so at least they've done it in the past. 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. The good news for shareholders is that I-HWA IndustrialLtd'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. As a result, some shareholders may be looking for stronger cash conversion in the current year.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of I-HWA IndustrialLtd.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by NT$108m, 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 analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. I-HWA IndustrialLtd had a rather significant contribution from unusual items relative to its profit to December 2020. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On I-HWA IndustrialLtd's Profit Performance

I-HWA IndustrialLtd had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at I-HWA IndustrialLtd's statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into I-HWA IndustrialLtd, you'd also look into what risks it is currently facing. For example, we've found that I-HWA IndustrialLtd has 4 warning signs (2 are potentially serious!) that deserve your attention before going any further with your analysis.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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. 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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