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. In this article, we'll look at how useful this year's statutory profit is, when analysing Provision InformationLTD (GTSM:6590).
We like the fact that Provision InformationLTD made a profit of NT$73.2m on its revenue of NT$432.1m, in the last year. In the chart below, you can see that its profit and revenue have both grown over the last three years.
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. So today we'll look at what Provision InformationLTD's cashflow tells us about its earnings, as well as examining how issuing shares is impacting shareholder value. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Provision InformationLTD.
Examining Cashflow Against Provision InformationLTD'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). 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.
Provision InformationLTD has an accrual ratio of -0.10 for the year to September 2020. That indicates that its free cash flow was a fair bit more than its statutory profit. Indeed, in the last twelve months it reported free cash flow of NT$99m, well over the NT$73.2m it reported in profit. Provision InformationLTD's free cash flow improved over the last year, which is generally good to see. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.
To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. Provision InformationLTD expanded the number of shares on issue by 20% over the last year. That means its earnings are split among a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. Check out Provision InformationLTD's historical EPS growth by clicking on this link.
A Look At The Impact Of Provision InformationLTD's Dilution on Its Earnings Per Share (EPS).
As you can see above, Provision InformationLTD has been growing its net income over the last few years, with an annualized gain of 1,699% over three years. But EPS was only up 1,205% per year, in the exact same period. And the 154% profit boost in the last year certainly seems impressive at first glance. But in comparison, EPS only increased by 109% over the same period. So you can see that the dilution has had a bit of an impact on shareholders. Therefore, the dilution is having a noteworthy influence on shareholder returns. And so, you can see quite clearly that dilution is influencing shareholder earnings.
Changes in the share price do tend to reflect changes in earnings per share, in the long run. So it will certainly be a positive for shareholders if Provision InformationLTD can grow EPS persistently. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.
Our Take On Provision InformationLTD's Profit Performance
At the end of the day, Provision InformationLTD is diluting shareholders which will dampen earnings per share growth, but its accrual ratio showed it can back up its profits with free cash flow. Having considered these factors, we don't think Provision InformationLTD's statutory profits give an overly harsh view of the business. So while earnings quality is important, it's equally important to consider the risks facing Provision InformationLTD at this point in time. For example, we've discovered 3 warning signs that you should run your eye over to get a better picture of Provision InformationLTD.
In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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. 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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