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. This article will consider whether Scan-D's (GTSM:6195) statutory profits are a good guide to its underlying earnings.
We like the fact that Scan-D made a profit of NT$174.4m on its revenue of NT$2.02b, in the last year. While it managed to grow its revenue over the last three years, its profit has moved in the other direction, as you can see in the chart below.
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 Scan-D'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 Scan-D.
Examining Cashflow Against Scan-D'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.
Scan-D has an accrual ratio of -0.37 for the year to September 2020. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of NT$627m during the period, dwarfing its reported profit of NT$174.4m. Scan-D shareholders are no doubt pleased that free cash flow improved over the last twelve months.
Our Take On Scan-D's Profit Performance
As we discussed above, Scan-D's accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Because of this, we think Scan-D's underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! 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. So while earnings quality is important, it's equally important to consider the risks facing Scan-D at this point in time. For example, Scan-D has 4 warning signs (and 1 which is significant) we think you should know about.
This note has only looked at a single factor that sheds light on the nature of Scan-D'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. 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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