Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it’s not always clear whether statutory profits are a good guide, going forward. In this article, we’ll look at how useful this year’s statutory profit is, when analysing Dong A Eltek (KOSDAQ:088130).
It’s good to see that over the last twelve months Dong A Eltek made a profit of ₩11.8b on revenue of ₩202.9b. The chart below shows that both revenue and profit have declined 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. So today we’ll look at what Dong A Eltek’s cashflow and unusual items tell 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 Dong A Eltek.
Zooming In On Dong A Eltek’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). 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. You could think of the accrual ratio from cashflow as the ‘non-FCF profit ratio’.
As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. While having an accrual ratio above zero is of little concern, we do think it’s worth noting when a company has a relatively high accrual ratio. To quote a 2014 paper by Lewellen and Resutek, “firms with higher accruals tend to be less profitable in the future”.
Over the twelve months to December 2019, Dong A Eltek recorded an accrual ratio of -0.26. 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 ₩41b, well over the ₩11.8b it reported in profit. Notably, Dong A Eltek had negative free cash flow last year, so the ₩41b it produced this year was a welcome improvement. 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?
Dong A Eltek’s profit was reduced by unusual items worth ₩2.9b 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, after all, that’s exactly what the accounting terminology implies. If Dong A Eltek 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 Dong A Eltek’s Profit Performance
Considering both Dong A Eltek’s accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company’s underlying earnings power. Based on these factors, we think Dong A Eltek’s underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! If you want to do dive deeper into Dong A Eltek, you’d also look into what risks it is currently facing. Every company has risks, and we’ve spotted 2 warning signs for Dong A Eltek you should know about.
After our examination into the nature of Dong A Eltek’s profit, we’ve come away optimistic for the company. 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. 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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.
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