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7. Quality of Profits
- The Chinese University of Hong Kong Press
- Chapter
- Additional Information
Chapter 7 Quality of Profits This chapter highlights the importance of sustainable profits by introducing the concept of quality of profits and includes the following sections: • Earning Capacity • Operating Items Affecting Quality of Profits • Non-Operating Items Affecting Quality of Profits • Financial Quality For the quantitative aspect, analysts generally consider the more profits earned by a corporation the better. Analysts should also consider the qualitative aspect. Quality of profits is a term to express the strength of a corporation’s earning capacity, i.e. the ability to generate profits (and cash flows) which are sustainable. The value of a corporation generally derives from its earning capacity. For analysts, assessing a corporation’s earning capacity requires expectations about the future. Many questions are prompted, such as: • Does a corporation have the ability to generate profits? • To what extent do these profits result in cash flows? • To what extent will these profits continue? All these are forward-looking questions, but financial statements in general show historical or current information based on a collection of past events and transactions. Most corporations tend to be comfortable in disclosing non-controversial issues. Corporate governance and past 122 Financial Analysis in Hong Kong (Second Edition) statistics are comprehensively covered, but they are reluctant to reveal too much about the future for fear of exposing information to their competitors and projecting performance that they are unable to deliver later. As forwardlooking information from the descriptive materials of annual report is very limited, analysts largely rely on historical or current information to assess a corporation’s ability to sustain its profits and cash flows. Earning Capacity Being profitable is not the same as having positive cash flows (see Chapter 6). Identifying profitable corporations which give a positive cash flow is not simple. Some profitable corporations may generate profits from non-recurring sources, i.e. those events or transactions which are unlikely to repeat or continue. In some cases, the reversals are forthcoming because losses or additional costs are only postponed or pushed forward to subsequent years (e.g. delay in recognizing potential losses from losing lawsuit). On the other hand, some corporations may record losses from non-recurring events or transactions (e.g. losses from disposals of factories or investments), so that better results or positive earnings are likely in the near future. To find sustainable sources and to assess the quality of profits, analysts need to go through corporations’ statements of comprehensive income in detail. Quality of profits may be viewed as a spectrum stretching from the highest quality to the lowest quality. An item on financial statements with high quality of profits signals positive contribution towards the corporation’s earning capacity. Low quality signals limited contribution towards earning capacity. The spectrum with the two extremes is illustrated in Figure 7.1. At the highest quality, the nature and amount of current year’s profit are expected to repeat in the foreseeable future. At the lowest quality, current year’s profit is not expected to recur in the years ahead. To illustrate the concept of quality of profits, reporting a $30 million gain from the disposal of fixed assets in the context of $100 million net profit reflects a low quality of profits for the current year because 30% (= $30 million / $100 million) of the net profit is derived from a non-recurring source. The gain which is significant in magnitude is unlikely to be repeated in [3.93.59.171] Project MUSE (2024-03-28 21:43 GMT) 7. Quality of Profits 123 subsequent years because fixed assets are required to maintain a corporation’s operations and there is only a limited pool of fixed assets. The corporation’s actual earning capacity (which may only be $70 million) is therefore lower than the reported profit of $100 million. In contrast, another corporation makes a provision for restructuring charges of $6 million and reports pre-tax profit of $50 million. The pre-tax profit without the restructuring provision is therefore $56 million, and the purpose of most restructurings is to change the scope of business or operation in order to improve the performance which by itself can increase the analysts’ confidence about the corporation’s future. The provision in the non-recurring nature can enhance the quality of profits in subsequent years, thus the corporation’s actual earning capacity (which may well be $56 million) is higher than the level as indicated by the reported profit of $50 million. Analysts are concerned with a corporation’s ability...