Here's Why We Think Alviva Holdings's (JSE:AVV) Statutory Earnings Might Be Conservative

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 Alviva Holdings' (JSE:AVV) statutory profits are a good guide to its underlying earnings.

We like the fact that Alviva Holdings made a profit of R148.7m on its revenue of R14.8b, in the last year. As you can see in the chart below, its profit has declined over the last three years, even though its revenue has increased.

Check out our latest analysis for Alviva Holdings

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, today we're going to take a closer look at Alviva Holdings' cashflow, and unusual items, with a view to understanding what these might tell us about its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Alviva Holdings.

A Closer Look At Alviva Holdings' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. 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.

For the year to June 2020, Alviva Holdings had an accrual ratio of -0.44. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of R1.4b, well over the R148.7m it reported in profit. Given that Alviva Holdings had negative free cash flow in the prior corresponding period, the trailing twelve month resul of R1.4b would seem to be a step in the right direction. 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.

The Impact Of Unusual Items On Profit

Alviva Holdings' profit was reduced by unusual items worth R52m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. If Alviva Holdings 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 Alviva Holdings' Profit Performance

In conclusion, both Alviva Holdings' accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. After considering all this, we reckon Alviva Holdings' statutory profit probably understates its earnings potential! So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example, we've found that Alviva Holdings has 5 warning signs (2 make us uncomfortable!) that deserve your attention before going any further with your analysis.

Our examination of Alviva Holdings has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. But there is always more to discover if you are capable of focussing your mind on minutiae. 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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