Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. 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. This article will consider whether Fuwei Films (Holdings)'s (NASDAQ:FFHL) statutory profits are a good guide to its underlying earnings.
It's good to see that over the last twelve months Fuwei Films (Holdings) made a profit of CN¥50.8m on revenue of CN¥337.2m. The good news is that the company managed to grow its revenue over the last three years, and also move from loss-making to profitable.
Importantly, statutory profits are not always the best tool for understanding a company's true earnings power, so it's well worth examining profits in a little more detail. So today we'll look at what Fuwei Films (Holdings)'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 Fuwei Films (Holdings).
A Closer Look At Fuwei Films (Holdings)'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. This ratio tells us how much of a company's profit is not backed by free cashflow.
As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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, Fuwei Films (Holdings) recorded an accrual ratio of -0.11. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. To wit, it produced free cash flow of CN¥85m during the period, dwarfing its reported profit of CN¥50.8m. Fuwei Films (Holdings)'s free cash flow improved over the last year, which is generally good to see.
Our Take On Fuwei Films (Holdings)'s Profit Performance
As we discussed above, Fuwei Films (Holdings) has perfectly satisfactory free cash flow relative to profit. Based on this observation, we consider it likely that Fuwei Films (Holdings)'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. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Case in point: We've spotted 3 warning signs for Fuwei Films (Holdings) you should be aware of.
This note has only looked at a single factor that sheds light on the nature of Fuwei Films (Holdings)'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. 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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