We're Not So Sure You Should Rely on Arlitech Electronic's (GTSM:6432) Statutory Earnings

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. 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. Today we'll focus on whether this year's statutory profits are a good guide to understanding Arlitech Electronic (GTSM:6432).

It's good to see that over the last twelve months Arlitech Electronic made a profit of NT$63.0m on revenue of NT$1.04b. 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 Arlitech Electronic

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. So today we'll examine what Arlitech Electronic's cashflow and its expanding share count tell us about the nature of its profits. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Arlitech Electronic.

A Closer Look At Arlitech Electronic's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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.

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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to September 2020, Arlitech Electronic had an accrual ratio of 0.34. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Even though it reported a profit of NT$63.0m, a look at free cash flow indicates it actually burnt through NT$68m in the last year. We saw that FCF was NT$51m a year ago though, so Arlitech Electronic has at least been able to generate positive FCF in the past. 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. Arlitech Electronic expanded the number of shares on issue by 28% over the last year. Therefore, each share now receives a smaller portion of profit. 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 Arlitech Electronic's historical EPS growth by clicking on this link.

How Is Dilution Impacting Arlitech Electronic's Earnings Per Share? (EPS)

As you can see above, Arlitech Electronic has been growing its net income over the last few years, with an annualized gain of 332% over three years. In comparison, earnings per share only gained 271% over the same period. And over the last 12 months, the company grew its profit by 5.0%. But earnings per share are actually down 3.5%, over the last twelve months. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

In the long term, if Arlitech Electronic's earnings per share can increase, then the share price should too. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

Our Take On Arlitech Electronic's Profit Performance

As it turns out, Arlitech Electronic couldn't match its profit with cashflow and its dilution means that shareholders own less of the company than the did before (unless they bought more shares). For the reasons mentioned above, we think that a perfunctory glance at Arlitech Electronic's statutory profits might make it look better than it really is on an underlying level. So while earnings quality is important, it's equally important to consider the risks facing Arlitech Electronic at this point in time. Our analysis shows 4 warning signs for Arlitech Electronic (1 is potentially serious!) and we strongly recommend you look at these before investing.

Our examination of Arlitech Electronic has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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. 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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