Ho Tung Chemical (TPE:1714) Is Growing Earnings But Are They A Good Guide?

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. Today we'll focus on whether this year's statutory profits are a good guide to understanding Ho Tung Chemical (TPE:1714).

We like the fact that Ho Tung Chemical made a profit of NT$1.78b on its revenue of NT$26.7b, in the last year. Even though its revenue is down over the last three years, its profit has actually increased, as you can see, below.

View our latest analysis for Ho Tung Chemical

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. So today we'll look at what Ho Tung Chemical'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 Ho Tung Chemical.

A Closer Look At Ho Tung Chemical's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. 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, Ho Tung Chemical had an accrual ratio of -0.25. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of NT$5.3b during the period, dwarfing its reported profit of NT$1.78b. Ho Tung Chemical's free cash flow improved over the last year, which is generally good to see.

Our Take On Ho Tung Chemical's Profit Performance

Happily for shareholders, Ho Tung Chemical produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that Ho Tung Chemical's statutory profit actually understates its earnings potential! And on top of that, its earnings per share have grown at an extremely impressive rate over the last three years. 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. Just as investors must consider earnings, it is also important to take into account the strength of a company's balance sheet. You can see our latest analysis on Ho Tung Chemical's balance sheet health here.

This note has only looked at a single factor that sheds light on the nature of Ho Tung Chemical's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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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