Kairuide HoldingLtd's (SZSE:002072) Earnings Are Weaker Than They Seem

Kairuide Holding Co.,Ltd. (SZSE:002072) just reported some strong earnings, and the market reacted accordingly with a healthy uplift in the share price. However, our analysis suggests that shareholders may be missing some factors that indicate the earnings result was not as good as it looked.

Check out our latest analysis for Kairuide HoldingLtd

A Closer Look At Kairuide HoldingLtd's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to June 2024, Kairuide HoldingLtd recorded an accrual ratio of -0.21. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of CN¥14m during the period, dwarfing its reported profit of CN¥7.17m. Notably, Kairuide HoldingLtd had negative free cash flow last year, so the CN¥14m it produced this year was a welcome improvement. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio).

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Kairuide HoldingLtd.

The Impact Of Unusual Items On Profit

Surprisingly, given Kairuide HoldingLtd's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥1.1m in unusual items. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And, after all, that's exactly what the accounting terminology implies. If Kairuide HoldingLtd doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that Kairuide HoldingLtd received a tax benefit of CN¥665k. This is meaningful because companies usually pay tax rather than receive tax benefits. Of course, prima facie it's great to receive a tax benefit. And since it previously lost money, it may well simply indicate the realisation of past tax losses. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth. So while we think it's great to receive a tax benefit, it does tend to imply an increased risk that the statutory profit overstates the sustainable earnings power of the business.

Our Take On Kairuide HoldingLtd's Profit Performance

In conclusion, Kairuide HoldingLtd's accrual ratio suggests its earnings are well backed by cash but its boost from unusual items, and a tax benefit, probably mean that the statutory number make the company seem more profitable than it is at an underlying level. Based on these factors, we think it's very unlikely that Kairuide HoldingLtd's statutory profits make it seem much weaker than it is. If you'd like to know more about Kairuide HoldingLtd as a business, it's important to be aware of any risks it's facing. Be aware that Kairuide HoldingLtd is showing 2 warning signs in our investment analysis and 1 of those is concerning...

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. But there is always more to discover if you are capable of focussing your mind on minutiae. Some people consider a high return on equity to be a good sign of a quality business. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks with high insider ownership.

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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.