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. This article will consider whether China Nuclear Energy Technology’s (HKG:611) statutory profits are a good guide to its underlying earnings.
We like the fact that China Nuclear Energy Technology made a profit of HK$86.5m on its revenue of HK$2.84b, in the last year. As you can see in the chart below, its profit has declined over the last three years, even though its revenue has increased.
Importantly, statutory profits are not always the best tool for understanding a company’s true earnings power, so it’s well worth examining profits in a little more detail. As a result, we think it’s well worth considering what China Nuclear Energy Technology’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 China Nuclear Energy Technology.
Zooming In On China Nuclear Energy Technology’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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.
Over the twelve months to June 2020, China Nuclear Energy Technology recorded an accrual ratio of 0.30. Therefore, we know that it’s free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Even though it reported a profit of HK$86.5m, a look at free cash flow indicates it actually burnt through HK$900m in the last year. We saw that FCF was HK$29m a year ago though, so China Nuclear Energy Technology has at least been able to generate positive FCF in the past.
Our Take On China Nuclear Energy Technology’s Profit Performance
China Nuclear Energy Technology didn’t convert much of its profit to free cash flow in the last year, which some investors may consider rather suboptimal. Therefore, it seems possible to us that China Nuclear Energy Technology’s true underlying earnings power is actually less than its statutory profit. In further bad news, its earnings per share decreased in the last year. At the end of the day, it’s essential to consider more than just the factors above, if you want to understand the company properly. Keep in mind, when it comes to analysing a stock it’s worth noting the risks involved. Case in point: We’ve spotted 4 warning signs for China Nuclear Energy Technology you should be mindful of and 2 of them are a bit concerning.
This note has only looked at a single factor that sheds light on the nature of China Nuclear Energy Technology’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.
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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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