Here's Why We Think Hollysys Automation Technologies' (NASDAQ:HOLI) Statutory Earnings Might Be Conservative

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. 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 Hollysys Automation Technologies (NASDAQ:HOLI).

It's good to see that over the last twelve months Hollysys Automation Technologies made a profit of US$70.2m on revenue of US$509.6m. As shown in the chart below, it did manage to grow its revenue over the last three years, although its profit has been pretty flat.

See our latest analysis for Hollysys Automation Technologies

Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. Therefore, we think it's worth taking a closer look at Hollysys Automation Technologies' cashflow, as well as examining the impact that unusual items have had on its reported profit. 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.

Zooming In On Hollysys Automation Technologies' 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. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to September 2020, Hollysys Automation Technologies recorded an accrual ratio of -0.18. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of US$147m in the last year, which was a lot more than its statutory profit of US$70.2m. Hollysys Automation Technologies' free cash flow improved over the last year, which is generally good to see. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

How Do Unusual Items Influence Profit?

Hollysys Automation Technologies' profit was reduced by unusual items worth US$36m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. If Hollysys Automation Technologies doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On Hollysys Automation Technologies' Profit Performance

In conclusion, both Hollysys Automation Technologies' accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. After considering all this, we reckon Hollysys Automation Technologies' statutory profit probably understates its earnings potential! 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 2 warning signs for Hollysys Automation Technologies you should be aware of.

Our examination of Hollysys Automation Technologies has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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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