Higgstec (GTSM:5220) Is Growing Earnings But Are They A Good Guide?

Broadly speaking, profitable businesses are less risky than unprofitable ones. 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. This article will consider whether Higgstec's (GTSM:5220) statutory profits are a good guide to its underlying earnings.

We like the fact that Higgstec made a profit of NT$145.8m on its revenue of NT$1.16b, in the last year. As depicted below, while its revenue may have fallen over the last few years, its profit actually improved.

Check out our latest analysis for Higgstec

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 Higgstec'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 Higgstec.

Zooming In On Higgstec'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. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. 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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Higgstec has an accrual ratio of 0.88 for the year to September 2020. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of NT$145.8m, a look at free cash flow indicates it actually burnt through NT$297m in the last year. We saw that FCF was NT$156m a year ago though, so Higgstec has at least been able to generate positive FCF in the past. The good news for shareholders is that Higgstec'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 Higgstec's Profit Performance

As we discussed above, we think Higgstec's earnings were not supported by free cash flow, which might concern some investors. As a result, we think it may well be the case that Higgstec's underlying earnings power is lower than its statutory profit. But at least holders can take some solace from the 20% per annum growth in EPS for the last three. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So while earnings quality is important, it's equally important to consider the risks facing Higgstec at this point in time. Our analysis shows 5 warning signs for Higgstec (1 is potentially serious!) and we strongly recommend you look at them before investing.

Today we've zoomed in on a single data point to better understand the nature of Higgstec's profit. 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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