Should You Use Alliance Material's (GTSM:3595) Statutory Earnings To Analyse It?

Statistically speaking, it is less risky to invest in profitable companies than in 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. In this article, we'll look at how useful this year's statutory profit is, when analysing Alliance Material (GTSM:3595).

We like the fact that Alliance Material made a profit of NT$42.4m on its revenue of NT$601.0m, in the last year.

See our latest analysis for Alliance Material

Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. So today we'll look at what Alliance Material's cashflow tells us about the quality of its earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Alliance Material.

Examining Cashflow Against Alliance Material'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. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to June 2020, Alliance Material had an accrual ratio of -0.15. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of NT$66m in the last year, which was a lot more than its statutory profit of NT$42.4m. Notably, Alliance Material had negative free cash flow last year, so the NT$66m it produced this year was a welcome improvement.

Our Take On Alliance Material's Profit Performance

Alliance Material's accrual ratio is solid, and indicates strong free cash flow, as we discussed, above. Because of this, we think Alliance Material's earnings potential is at least as good as it seems, and maybe even better! And on top of that, its earnings per share increased by 10% in the last year. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. If you'd like to know more about Alliance Material as a business, it's important to be aware of any risks it's facing. At Simply Wall St, we found 3 warning signs for Alliance Material and we think they deserve your attention.

Today we've zoomed in on a single data point to better understand the nature of Alliance Material's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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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