Here's Why We Don't Think Luo Lih-Fen Holding's (TPE:6666) Statutory Earnings Reflect Its Underlying Earnings Potential

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. That said, the current statutory profit is not always a good guide to a company's underlying profitability. In this article, we'll look at how useful this year's statutory profit is, when analysing Luo Lih-Fen Holding (TPE:6666).

We like the fact that Luo Lih-Fen Holding made a profit of NT$175.7m on its revenue of NT$909.8m, in the last year. As you can see in the chart below, its profit has declined over the last three years, even though its revenue has increased.

Check out our latest analysis for Luo Lih-Fen Holding

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. Thus, we will today look at Luo Lih-Fen Holding's cashflow relative to its earnings, and consider how a tax benefit has impacted its statutory profit. That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

Zooming In On Luo Lih-Fen Holding'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. 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.

Over the twelve months to September 2020, Luo Lih-Fen Holding recorded an accrual ratio of 0.54. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. In the last twelve months it actually had negative free cash flow, with an outflow of NT$60m despite its profit of NT$175.7m, mentioned above. It's worth noting that Luo Lih-Fen Holding generated positive FCF of NT$49m a year ago, so at least they've done it in the past. Importantly, we note an unusual tax situation, which we discuss below, has impacted the accruals ratio. This would certainly have contributed to the weak cash conversion.

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that Luo Lih-Fen Holding received a tax benefit of NT$29m. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! We're sure the company was pleased with its tax benefit. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal.

Our Take On Luo Lih-Fen Holding's Profit Performance

This year, Luo Lih-Fen Holding couldn't match its profit with cashflow. If the tax benefit is not repeated, then profit would drop next year, all else being equal. Considering all this we'd argue Luo Lih-Fen Holding's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Luo Lih-Fen Holding as a business, it's important to be aware of any risks it's facing. Our analysis shows 3 warning signs for Luo Lih-Fen Holding (1 makes us a bit uncomfortable!) and we strongly recommend you look at them before investing.

Our examination of Luo Lih-Fen Holding 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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