Here's Why Lien Chang Electronic Enterprise's (TPE:2431) Statutory Earnings Are Arguably Too Conservative

Statistically speaking, it is less risky to invest in profitable companies than in 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 Lien Chang Electronic Enterprise's (TPE:2431) statutory profits are a good guide to its underlying earnings.

While Lien Chang Electronic Enterprise was able to generate revenue of NT$2.44b in the last twelve months, we think its profit result of NT$52.2m was more important.

View our latest analysis for Lien Chang Electronic Enterprise

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 Lien Chang Electronic Enterprise'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 Lien Chang Electronic Enterprise.

Zooming In On Lien Chang Electronic Enterprise'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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to September 2020, Lien Chang Electronic Enterprise recorded an accrual ratio of -0.29. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of NT$315m during the period, dwarfing its reported profit of NT$52.2m. Given that Lien Chang Electronic Enterprise had negative free cash flow in the prior corresponding period, the trailing twelve month resul of NT$315m would seem to be a step in the right direction.

Our Take On Lien Chang Electronic Enterprise's Profit Performance

Happily for shareholders, Lien Chang Electronic Enterprise produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that Lien Chang Electronic Enterprise's statutory profit actually understates its earnings potential! And one can definitely find a positive in the fact that it made a profit this year, despite losing money last year. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. For instance, we've identified 2 warning signs for Lien Chang Electronic Enterprise (1 is a bit unpleasant) you should be familiar with.

Today we've zoomed in on a single data point to better understand the nature of Lien Chang Electronic Enterprise's profit. But there are plenty of other ways to inform your opinion of a company. 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. 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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