As a general rule, we think profitable companies are less risky than companies that lose money. 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 Combined Motor Holdings' (JSE:CMH) statutory profits are a good guide to its underlying earnings.
We like the fact that Combined Motor Holdings made a profit of R85.7m on its revenue of R8.99b, in the last year. Below, you can see that both its revenue and its profit have fallen over the last three years.
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. As a result, we think it's well worth considering what Combined Motor Holdings' cashflow (when compared to its earnings) can tell us about the nature of its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Combined Motor Holdings.
Zooming In On Combined Motor Holdings' 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. 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.
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. 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.
Over the twelve months to August 2020, Combined Motor Holdings recorded an accrual ratio of -0.43. 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 R431m during the period, dwarfing its reported profit of R85.7m. Combined Motor Holdings' free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons.
Our Take On Combined Motor Holdings' Profit Performance
Happily for shareholders, Combined Motor Holdings produced plenty of free cash flow to back up its statutory profit numbers. Because of this, we think Combined Motor Holdings' underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! On the other hand, its EPS actually shrunk in the last twelve months. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Our analysis shows 6 warning signs for Combined Motor Holdings (2 make us uncomfortable!) and we strongly recommend you look at them before investing.
Today we've zoomed in on a single data point to better understand the nature of Combined Motor Holdings' 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. 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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