Here’s Why We Don’t Think China Oriental Group’s (HKG:581) Statutory Earnings Reflect Its Underlying Earnings Potential

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. That said, the current statutory profit is not always a good guide to a company’s underlying profitability. In this article, we’ll look at how useful this year’s statutory profit is, when analysing China Oriental Group (HKG:581).

It’s good to see that over the last twelve months China Oriental Group made a profit of CN¥3.21b on revenue of CN¥43.0b. In the chart below, you can see that its profit and revenue have both grown over the last three years, although its profit has slipped in the last twelve months.

Check out our latest analysis for China Oriental Group

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SEHK:581 Earnings and Revenue History July 14th 2020

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 China Oriental Group’s cashflow and unusual items tell us about the quality of its earnings. That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

A Closer Look At China Oriental 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. The ratio shows us how much a company’s profit exceeds its FCF.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to December 2019, China Oriental Group had an accrual ratio of 0.48. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of CN¥3.21b, a look at free cash flow indicates it actually burnt through CN¥2.7b in the last year. It’s worth noting that China Oriental Group generated positive FCF of CN¥7.8b a year ago, so at least they’ve done it in the past. 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. One positive for China Oriental Group shareholders is that it’s accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it’s not overly surprising that China Oriental Group’s profit was boosted by unusual items worth CN¥318m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that’s exactly what the accounting terminology implies. Assuming those unusual items don’t show up again in the current year, we’d thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On China Oriental Group’s Profit Performance

Summing up, China Oriental Group received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For the reasons mentioned above, we think that a perfunctory glance at China Oriental Group’s statutory profits might make it look better than it really is on an underlying level. If you’d like to know more about China Oriental Group as a business, it’s important to be aware of any risks it’s facing. Every company has risks, and we’ve spotted 3 warning signs for China Oriental Group (of which 1 shouldn’t be ignored!) you should know about.

Our examination of China Oriental Group has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. But there is always more to discover if you are capable of focussing your mind on minutiae. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to ‘follow the money’ and search out stocks that insiders are buying. 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.

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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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