Are Kunyue Development's (GTSM:5206) Statutory Earnings A Good Guide To Its Underlying Profitability?

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. 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. This article will consider whether Kunyue Development's (GTSM:5206) statutory profits are a good guide to its underlying earnings.

While Kunyue Development was able to generate revenue of NT$2.26b in the last twelve months, we think its profit result of NT$355.9m was more important. Happily, it has grown both its profit and revenue over the last three years (but not in the last year), as you can see in the chart below.

See our latest analysis for Kunyue Development

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 Kunyue Development'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 Kunyue Development.

Examining Cashflow Against Kunyue Development's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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. The ratio shows us how much a company's profit exceeds its FCF.

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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to September 2020, Kunyue Development recorded an accrual ratio of 0.27. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Even though it reported a profit of NT$355.9m, a look at free cash flow indicates it actually burnt through NT$1.1b in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of NT$1.1b, this year, indicates high risk.

Our Take On Kunyue Development's Profit Performance

Kunyue Development didn't convert much of its profit to free cash flow in the last year, which some investors may consider rather suboptimal. Therefore, it seems possible to us that Kunyue Development's true underlying earnings power is actually less than its statutory profit. But the good news is that its EPS growth over the last three years has been very impressive. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For example, we've found that Kunyue Development has 4 warning signs (2 are a bit concerning!) that deserve your attention before going any further with your analysis.

This note has only looked at a single factor that sheds light on the nature of Kunyue Development's 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. 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.

If you decide to trade Kunyue Development, use the lowest-cost* platform that is rated #1 Overall by Barron’s, Interactive Brokers. Trade stocks, options, futures, forex, bonds and funds on 135 markets, all from a single integrated account. Promoted

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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.