Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. 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. This article will consider whether Chinney Alliance Group‘s (HKG:385) statutory profits are a good guide to its underlying earnings.
We like the fact that Chinney Alliance Group made a profit of HK$200.7m on its revenue of HK$5.73b, in the last year. One positive is that it has grown both its profit and its revenue, over the last few 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 Chinney Alliance Group’s 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 Chinney Alliance Group.
Examining Cashflow Against Chinney Alliance 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. 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. The ratio shows us how much a company’s profit exceeds its FCF.
As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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.
For the year to June 2019, Chinney Alliance Group had an accrual ratio of 0.28. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. Even though it reported a profit of HK$200.7m, a look at free cash flow indicates it actually burnt through HK$183m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of HK$183m, this year, indicates high risk.
This would partially explain why the accrual ratio was so poor.
Our Take On Chinney Alliance Group’s Profit Performance
Chinney Alliance Group’s accrual ratio for the last twelve months signifies cash conversion is less than ideal, which is a negative when it comes to our view of its earnings. Because of this, we think that it may be that Chinney Alliance Group’s statutory profits are better than its underlying earnings power. Nonetheless, it’s still worth noting that its earnings per share have grown at 21% over the last three years. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company’s potential, but there is plenty more to consider. Just as investors must consider earnings, it is also important to take into account the strength of a company’s balance sheet. If you want to,you can see our take on Chinney Alliance Group’s balance sheet by clicking here.
Today we’ve zoomed in on a single data point to better understand the nature of Chinney Alliance Group’s 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.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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.
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