Cheng De Lolo's (SZSE:000848) Profits Appear To Have Quality Issues

Cheng De Lolo Company Limited's (SZSE:000848) robust recent earnings didn't do much to move the stock. We think this is due to investors looking beyond the statutory profits and being concerned with what they see.

See our latest analysis for Cheng De Lolo

Zooming In On Cheng De Lolo's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Cheng De Lolo has an accrual ratio of 1.25 for the year to June 2024. Ergo, its free cash flow is significantly weaker than its profit. Statistically speaking, that's a real negative for future earnings. In fact, it had free cash flow of CN¥314m in the last year, which was a lot less than its statutory profit of CN¥616.7m. Cheng De Lolo shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months.

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.

Our Take On Cheng De Lolo's Profit Performance

As we have made quite clear, we're a bit worried that Cheng De Lolo didn't back up the last year's profit with free cashflow. As a result, we think it may well be the case that Cheng De Lolo's underlying earnings power is lower than its statutory profit. But at least holders can take some solace from the 21% per annum growth in EPS for the last three. 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. So while earnings quality is important, it's equally important to consider the risks facing Cheng De Lolo at this point in time. To that end, you should learn about the 2 warning signs we've spotted with Cheng De Lolo (including 1 which is a bit unpleasant).

This note has only looked at a single factor that sheds light on the nature of Cheng De Lolo'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 with significant insider holdings to be useful.

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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.