Some Investors May Be Willing To Look Past Yuanda China Holdings' (HKG:2789) Soft Earnings

Shareholders appeared unconcerned with Yuanda China Holdings Limited's (HKG:2789) lackluster earnings report last week. We did some digging, and we believe the earnings are stronger than they seem.

See our latest analysis for Yuanda China Holdings

Examining Cashflow Against Yuanda China Holdings' 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. 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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.

Yuanda China Holdings has an accrual ratio of -0.15 for the year to December 2023. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of CN¥348m during the period, dwarfing its reported profit of CN¥25.3m. Yuanda China Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio.

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

How Do Unusual Items Influence Profit?

Yuanda China Holdings' profit was reduced by unusual items worth CN¥20m 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. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. In the twelve months to December 2023, Yuanda China Holdings had a big unusual items expense. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that Yuanda China Holdings received a tax benefit of CN¥5.5m. This is meaningful because companies usually pay tax rather than receive tax benefits. Of course, prima facie it's great to receive a tax benefit. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth. While we think it's good that the company has booked a tax benefit, it does mean that there's every chance the statutory profit will come in a lot higher than it would be if the income was adjusted for one-off factors.

Our Take On Yuanda China Holdings' Profit Performance

In conclusion, both Yuanda China Holdings' accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative, but the presence of a tax benefits may be inflating the numbers in a way that won't persist. Looking at all these factors, we'd say that Yuanda China Holdings' underlying earnings power is at least as good as the statutory numbers would make it seem. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. When we did our research, we found 4 warning signs for Yuanda China Holdings (1 is significant!) that we believe deserve your full attention.

Our examination of Yuanda China Holdings 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. 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 that insiders are buying 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.