Here's Why We Think Xingye Alloy Materials Group's (HKG:505) Statutory Earnings Might Be Conservative

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. Today we'll focus on whether this year's statutory profits are a good guide to understanding Xingye Alloy Materials Group (HKG:505).

It's good to see that over the last twelve months Xingye Alloy Materials Group made a profit of CN¥47.6m on revenue of CN¥4.26b. The chart below shows how it has grown revenue over the last three years, but that profit has declined.

Check out our latest analysis for Xingye Alloy Materials Group

Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. Therefore, we think it's worth taking a closer look at Xingye Alloy Materials Group's cashflow, as well as examining the impact that unusual items have had on its reported profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Xingye Alloy Materials Group.

A Closer Look At Xingye Alloy Materials 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. 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. 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".

Xingye Alloy Materials Group has an accrual ratio of -0.24 for the year to June 2020. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. In fact, it had free cash flow of CN¥442m in the last year, which was a lot more than its statutory profit of CN¥47.6m. Notably, Xingye Alloy Materials Group had negative free cash flow last year, so the CN¥442m it produced this year was a welcome improvement. 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.

How Do Unusual Items Influence Profit?

Xingye Alloy Materials Group's profit was reduced by unusual items worth CN¥27m 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. Assuming those unusual expenses don't come up again, we'd therefore expect Xingye Alloy Materials Group to produce a higher profit next year, all else being equal.

Our Take On Xingye Alloy Materials Group's Profit Performance

In conclusion, both Xingye Alloy Materials Group's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. After considering all this, we reckon Xingye Alloy Materials Group's statutory profit probably understates its earnings potential! So while earnings quality is important, it's equally important to consider the risks facing Xingye Alloy Materials Group at this point in time. In terms of investment risks, we've identified 2 warning signs with Xingye Alloy Materials Group, and understanding these bad boys should be part of your investment process.

After our examination into the nature of Xingye Alloy Materials Group's profit, we've come away optimistic for the company. But there is always more to discover if you are capable of focussing your mind on minutiae. Some people consider a high return on equity to be a good sign of a quality business. 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. 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.
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