Investors Can Find Comfort In China Chengtong Development Group's (HKG:217) Earnings Quality

Soft earnings didn't appear to concern China Chengtong Development Group Limited's (HKG:217) shareholders over the last week. We think that the softer headline numbers might be getting counterbalanced by some positive underlying factors.

We've discovered 3 warning signs about China Chengtong Development Group. View them for free.

A Closer Look At China Chengtong Development Group's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

China Chengtong Development Group has an accrual ratio of -0.30 for the year to December 2024. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of HK$2.4b during the period, dwarfing its reported profit of HK$38.6m. Given that China Chengtong Development Group had negative free cash flow in the prior corresponding period, the trailing twelve month resul of HK$2.4b would seem to be a step in the right direction. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

See our latest analysis for China Chengtong Development Group

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of China Chengtong Development Group.

How Do Unusual Items Influence Profit?

China Chengtong Development Group's profit was reduced by unusual items worth HK$11m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. If China Chengtong Development Group doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On China Chengtong Development Group's Profit Performance

In conclusion, both China Chengtong Development Group's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. After considering all this, we reckon China Chengtong Development Group's statutory profit probably understates its earnings potential! With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Our analysis shows 3 warning signs for China Chengtong Development Group (1 is significant!) and we strongly recommend you look at these before investing.

Our examination of China Chengtong Development Group has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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.