Investors Can Find Comfort In Cangzhou Dahua's (SHSE:600230) Earnings Quality

Shareholders appeared unconcerned with Cangzhou Dahua Co., Ltd.'s (SHSE:600230) lackluster earnings report last week. Our analysis suggests that while the profits are soft, the foundations of the business are strong.

View our latest analysis for Cangzhou Dahua

Examining Cashflow Against Cangzhou Dahua'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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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.

Cangzhou Dahua has an accrual ratio of -0.12 for the year to June 2024. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. Indeed, in the last twelve months it reported free cash flow of CN¥677m, well over the CN¥98.3m it reported in profit. Cangzhou Dahua shareholders are no doubt pleased that free cash flow improved over the last twelve months.

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

Our Take On Cangzhou Dahua's Profit Performance

As we discussed above, Cangzhou Dahua has perfectly satisfactory free cash flow relative to profit. Based on this observation, we consider it likely that Cangzhou Dahua's statutory profit actually understates its earnings potential! Unfortunately, though, its earnings per share actually fell back over the last year. 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 Cangzhou Dahua at this point in time. At Simply Wall St, we found 2 warning signs for Cangzhou Dahua and we think they deserve your attention.

This note has only looked at a single factor that sheds light on the nature of Cangzhou Dahua's profit. 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 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.