Should You Use Gallant Precision Machining's (GTSM:5443) Statutory Earnings To Analyse It?

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. 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. In this article, we'll look at how useful this year's statutory profit is, when analysing Gallant Precision Machining (GTSM:5443).

While Gallant Precision Machining was able to generate revenue of NT$3.34b in the last twelve months, we think its profit result of NT$119.8m was more important. As depicted below, while its revenue may have fallen over the last few years, its profit actually improved.

See our latest analysis for Gallant Precision Machining

Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. Therefore, we think it's worth taking a closer look at Gallant Precision Machining's cashflow, as well as examining the impact that unusual items have had on its reported profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Gallant Precision Machining.

A Closer Look At Gallant Precision Machining'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. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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, Gallant Precision Machining recorded an accrual ratio of -0.27. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of NT$647m in the last year, which was a lot more than its statutory profit of NT$119.8m. Given that Gallant Precision Machining had negative free cash flow in the prior corresponding period, the trailing twelve month resul of NT$647m would seem to be a step in the right direction. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

How Do Unusual Items Influence Profit?

Surprisingly, given Gallant Precision Machining's accrual ratio implied strong cash conversion, its paper profit was actually boosted by NT$87m in unusual items. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And that's as you'd expect, given these boosts are described as 'unusual'. Gallant Precision Machining had a rather significant contribution from unusual items relative to its profit to September 2020. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Gallant Precision Machining's Profit Performance

In conclusion, Gallant Precision Machining's accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Given the contrasting considerations, we don't have a strong view as to whether Gallant Precision Machining's profits are an apt reflection of its underlying potential for profit. So while earnings quality is important, it's equally important to consider the risks facing Gallant Precision Machining at this point in time. For instance, we've identified 6 warning signs for Gallant Precision Machining (1 is potentially serious) you should be familiar with.

Our examination of Gallant Precision Machining has focussed on certain factors that can make its earnings look better than they are. But there are plenty of other ways to inform your opinion of a company. 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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