China PengFei Group's (HKG:3348) Conservative Accounting Might Explain Soft Earnings

China PengFei Group Limited's (HKG:3348) recent soft profit numbers didn't appear to worry shareholders, as the stock price showed strength. Our analysis suggests that investors may have noticed some promising signs beyond the statutory profit figures.

Check out our latest analysis for China PengFei Group

Zooming In On China PengFei Group'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. 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'.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

China PengFei Group has an accrual ratio of -0.29 for the year to June 2024. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of CN¥208m during the period, dwarfing its reported profit of CN¥110.2m. Given that China PengFei Group had negative free cash flow in the prior corresponding period, the trailing twelve month resul of CN¥208m would seem to be a step in the right direction.

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

Our Take On China PengFei Group's Profit Performance

Happily for shareholders, China PengFei Group produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that China PengFei Group's statutory profit actually understates its earnings potential! On the other hand, its EPS actually shrunk in the last twelve months. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So while earnings quality is important, it's equally important to consider the risks facing China PengFei Group at this point in time. Every company has risks, and we've spotted 2 warning signs for China PengFei Group you should know about.

Today we've zoomed in on a single data point to better understand the nature of China PengFei Group'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.