CNNC International's (HKG:2302) Profits Appear To Have Quality Issues

The recent earnings posted by CNNC International Limited (HKG:2302) were solid, but the stock didn't move as much as we expected. We think this is due to investors looking beyond the statutory profits and being concerned with what they see.

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Zooming In On CNNC International's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

CNNC International has an accrual ratio of 0.21 for the year to December 2024. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. To wit, it produced free cash flow of HK$139m during the period, falling well short of its reported profit of HK$195.0m. At this point we should mention that CNNC International did manage to increase its free cash flow in the last twelve months 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.

Check out our latest analysis for CNNC International

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

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that CNNC International's profit was boosted by unusual items worth HK$23m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. If CNNC International 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 CNNC International's Profit Performance

Summing up, CNNC International received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue CNNC International's profits probably give an overly generous impression of its sustainable level of profitability. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. When we did our research, we found 2 warning signs for CNNC International (1 is concerning!) that we believe deserve your full attention.

Our examination of CNNC International has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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. 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.