Is There More To The Story Than Channel Well TechnologyLtd's (GTSM:3078) Earnings Growth?

As a general rule, we think profitable companies are less risky than companies that lose money. 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 Channel Well TechnologyLtd (GTSM:3078).

It's good to see that over the last twelve months Channel Well TechnologyLtd made a profit of NT$823.1m on revenue of NT$6.52b. Happily, it has grown both its profit and revenue over the last three years, as you can see in the chart below.

See our latest analysis for Channel Well TechnologyLtd

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. Today, we'll discuss Channel Well TechnologyLtd'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 Channel Well TechnologyLtd.

Examining Cashflow Against Channel Well TechnologyLtd'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.

Channel Well TechnologyLtd has an accrual ratio of 0.38 for the year to September 2020. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. In fact, it had free cash flow of NT$107m in the last year, which was a lot less than its statutory profit of NT$823.1m. Channel Well TechnologyLtd shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months. The good news for shareholders is that Channel Well TechnologyLtd's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

Our Take On Channel Well TechnologyLtd's Profit Performance

As we discussed above, we think Channel Well TechnologyLtd's earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that Channel Well TechnologyLtd's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But at least holders can take some solace from the 15% per annum growth in EPS for the last three. 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. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. While conducting our analysis, we found that Channel Well TechnologyLtd has 2 warning signs and it would be unwise to ignore them.

This note has only looked at a single factor that sheds light on the nature of Channel Well TechnologyLtd'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. 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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