We Wouldn't Rely On WE & WIN Development's (TPE:2537) Statutory Earnings As A Guide

As a general rule, we think profitable companies are less risky than companies that lose money. That said, the current statutory profit is not always a good guide to a company's underlying profitability. This article will consider whether WE & WIN Development's (TPE:2537) statutory profits are a good guide to its underlying earnings.

We like the fact that WE & WIN Development made a profit of NT$52.9m on its revenue of NT$1.52b, in the last year. At the risk of seeming quaint, we do like to at least examine profit, even when a stock is improving revenue and considered a 'growth stock'. The good news is that the company managed to grow its revenue over the last three years, and also move from loss-making to profitable.

Check out our latest analysis for WE & WIN Development

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. Today, we'll discuss WE & WIN Development'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 WE & WIN Development.

A Closer Look At WE & WIN Development'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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. 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. 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, WE & WIN Development recorded an accrual ratio of 0.33. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. Even though it reported a profit of NT$52.9m, a look at free cash flow indicates it actually burnt through NT$2.7b in the last year. We also note that WE & WIN Development's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of NT$2.7b. One positive for WE & WIN Development shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Our Take On WE & WIN Development's Profit Performance

As we discussed above, we think WE & WIN Development's earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that WE & WIN Development's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. On the bright side, the company showed enough improvement to book a profit this year, after losing money 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. So while earnings quality is important, it's equally important to consider the risks facing WE & WIN Development at this point in time. In terms of investment risks, we've identified 3 warning signs with WE & WIN Development, and understanding these bad boys should be part of your investment process.

Today we've zoomed in on a single data point to better understand the nature of WE & WIN 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. 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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