Here's Why Kuo Yang ConstructionLtd's (TPE:2505) Statutory Earnings Are Arguably Too Conservative

Broadly speaking, profitable businesses are less risky than unprofitable ones. That said, the current statutory profit is not always a good guide to a company's underlying profitability. Today we'll focus on whether this year's statutory profits are a good guide to understanding Kuo Yang ConstructionLtd (TPE:2505).

While Kuo Yang ConstructionLtd was able to generate revenue of NT$11.6b in the last twelve months, we think its profit result of NT$4.83b was more important.

View our latest analysis for Kuo Yang ConstructionLtd

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. Today, we'll discuss Kuo Yang ConstructionLtd's free cashflow relative to its earnings, and consider what that tells us about the company. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Kuo Yang ConstructionLtd.

Zooming In On Kuo Yang ConstructionLtd's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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 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.

Kuo Yang ConstructionLtd has an accrual ratio of -0.27 for the year to September 2020. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of NT$8.4b, well over the NT$4.83b it reported in profit. Notably, Kuo Yang ConstructionLtd had negative free cash flow last year, so the NT$8.4b it produced this year was a welcome improvement.

Our Take On Kuo Yang ConstructionLtd's Profit Performance

Happily for shareholders, Kuo Yang ConstructionLtd produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that Kuo Yang ConstructionLtd'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 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 Kuo Yang ConstructionLtd as a business, it's important to be aware of any risks it's facing. Every company has risks, and we've spotted 3 warning signs for Kuo Yang ConstructionLtd you should know about.

Today we've zoomed in on a single data point to better understand the nature of Kuo Yang ConstructionLtd'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. 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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