Chuan Holdings (HKG:1420) Posted Healthy Earnings But There Are Some Other Factors To Be Aware Of

Investors were disappointed with Chuan Holdings Limited's (HKG:1420) earnings, despite the strong profit numbers. We think that the market might be paying attention to some underlying factors that they find to be concerning.

Check out our latest analysis for Chuan Holdings

A Closer Look At Chuan Holdings' 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 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.

Over the twelve months to December 2023, Chuan Holdings recorded an accrual ratio of -0.20. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of S$16m, well over the S$3.25m it reported in profit. Notably, Chuan Holdings had negative free cash flow last year, so the S$16m it produced this year was a welcome improvement. Having said that, there is more to consider. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively.

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

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. In fact, Chuan Holdings increased the number of shares on issue by 22% over the last twelve months by issuing new shares. As a result, its net income is now split between a greater number of shares. To talk about net income, without noticing earnings per share, is to be distracted by the big numbers while ignoring the smaller numbers that talk to per share value. Check out Chuan Holdings' historical EPS growth by clicking on this link.

A Look At The Impact Of Chuan Holdings' Dilution On Its Earnings Per Share (EPS)

Chuan Holdings was losing money three years ago. On the bright side, in the last twelve months it grew profit by 88%. On the other hand, earnings per share are only up 88% over the same period. And so, you can see quite clearly that dilution is influencing shareholder earnings.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So Chuan Holdings shareholders will want to see that EPS figure continue to increase. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

How Do Unusual Items Influence Profit?

Surprisingly, given Chuan Holdings' accrual ratio implied strong cash conversion, its paper profit was actually boosted by S$2.4m in unusual items. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's as you'd expect, given these boosts are described as 'unusual'. Chuan Holdings had a rather significant contribution from unusual items relative to its profit to December 2023. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Chuan Holdings' Profit Performance

In conclusion, Chuan Holdings' accrual ratio suggests its earnings are well backed by cash but its boost from unusual items is probably not going to be repeated consistently. Further, the dilution means profits are now split more ways. Based on these factors, we think that Chuan Holdings' statutory profits probably make it seem better than it is on an underlying level. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Case in point: We've spotted 3 warning signs for Chuan Holdings you should be mindful of and 1 of these bad boys is significant.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. But there are plenty of other ways to inform your opinion of a company. 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 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.