We Think Formosa International Hotels' (TPE:2707) Statutory Profit Might Understate Its Earnings Potential

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. That said, the current statutory profit is not always a good guide to a company's underlying profitability. This article will consider whether Formosa International Hotels' (TPE:2707) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Formosa International Hotels made a profit of NT$762.8m on revenue of NT$5.57b. Below, you can see that both its revenue and its profit have fallen over the last three years.

Check out our latest analysis for Formosa International Hotels

Not all profits are equal, and we can learn more about the nature of a company's past profitability by diving deeper into the financial statements. As a result, we think it's well worth considering what Formosa International Hotels' 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 Formosa International Hotels.

Examining Cashflow Against Formosa International Hotels' 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. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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.

For the year to September 2020, Formosa International Hotels had an accrual ratio of -0.50. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of NT$2.2b, well over the NT$762.8m it reported in profit. Formosa International Hotels' free cash flow improved over the last year, which is generally good to see.

Our Take On Formosa International Hotels' Profit Performance

Happily for shareholders, Formosa International Hotels produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that Formosa International Hotels' statutory profit actually understates its earnings potential! On the other hand, its EPS actually shrunk in the last twelve months. 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. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. At Simply Wall St, we found 3 warning signs for Formosa International Hotels and we think they deserve your attention.

This note has only looked at a single factor that sheds light on the nature of Formosa International Hotels' 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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