Harbor Custom Development's (NASDAQ:HCDI) Solid Profits Have Weak Fundamentals

Despite posting some strong earnings, the market for Harbor Custom Development, Inc.'s (NASDAQ:HCDI) stock hasn't moved much. Our analysis suggests that shareholders have noticed something concerning in the numbers.

See our latest analysis for Harbor Custom Development

A Closer Look At Harbor Custom Development's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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.

Harbor Custom Development has an accrual ratio of 1.21 for the year to December 2021. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of US$6.13m, a look at free cash flow indicates it actually burnt through US$87m in the last year. It's worth noting that Harbor Custom Development generated positive FCF of US$2.6m a year ago, so at least they've done it in the past. One positive for Harbor Custom Development shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. As a result, some shareholders may be looking for stronger cash conversion in the current year.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

Our Take On Harbor Custom Development's Profit Performance

As we have made quite clear, we're a bit worried that Harbor Custom Development didn't back up the last year's profit with free cashflow. For this reason, we think that Harbor Custom Development's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. The good news is that it earned a profit in the last twelve months, despite its previous loss. 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. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example, Harbor Custom Development has 3 warning signs (and 1 which is a bit concerning) we think you should know about.

This note has only looked at a single factor that sheds light on the nature of Harbor Custom Development'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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.