Investors were disappointed with the weak earnings posted by ICO Group Limited (HKG:1460 ). While the headline numbers were soft, we believe that investors might be missing some encouraging factors.
See our latest analysis for ICO Group
Examining Cashflow Against ICO Group’s Earnings
One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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 September 2023, ICO Group recorded an accrual ratio of -0.20. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of HK$93m, well over the HK$10.1m it reported in profit. ICO Group shareholders are no doubt pleased that free cash flow improved over the last twelve months. However, that’s not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.
Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of ICO Group.
How Do Unusual Items Influence Profit?
ICO Group’s profit was reduced by unusual items worth HK$21m 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. 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. In the twelve months to September 2023, ICO Group had a big unusual items expense. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.
Our Take On ICO Group’s Profit Performance
In conclusion, both ICO Group’s accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Based on these factors, we think ICO Group’s underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! So if you’d like to dive deeper into this stock, it’s crucial to consider any risks it’s facing. Case in point: We’ve spotted 4 warning signs for ICO Group you should be mindful of and 1 of these is significant.
Our examination of ICO Group 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. 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.
Valuation is complex, but we’re helping make it simple.
Find out whether ICO Group is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.
