Statutory Profit Doesn't Reflect How Good Chengdu Hongqi ChainLtd's (SZSE:002697) Earnings Are

Chengdu Hongqi Chain Co.,Ltd. (SZSE:002697) recently posted some strong earnings, and the market responded positively. We have done some analysis, and we found several positive factors beyond the profit numbers.

Check out our latest analysis for Chengdu Hongqi ChainLtd

Examining Cashflow Against Chengdu Hongqi ChainLtd's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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.

Chengdu Hongqi ChainLtd has an accrual ratio of -0.32 for the year to December 2023. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of CN¥1.2b, well over the CN¥561.1m it reported in profit. Chengdu Hongqi ChainLtd's free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

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.

How Do Unusual Items Influence Profit?

Surprisingly, given Chengdu Hongqi ChainLtd's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥53m in unusual items. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. 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. Which is hardly surprising, given the name. If Chengdu Hongqi ChainLtd doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Chengdu Hongqi ChainLtd's Profit Performance

Chengdu Hongqi ChainLtd's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Considering all the aforementioned, we'd venture that Chengdu Hongqi ChainLtd's profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. If you'd like to know more about Chengdu Hongqi ChainLtd as a business, it's important to be aware of any risks it's facing. At Simply Wall St, we found 1 warning sign for Chengdu Hongqi ChainLtd and we think they deserve your attention.

Our examination of Chengdu Hongqi ChainLtd has focussed on certain factors that can make its earnings look better than they are. 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 that insiders are buying.

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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.