We Think You Should Be Aware Of Some Concerning Factors In China Tangshang Holdings' (HKG:674) Earnings

China Tangshang Holdings Limited's (HKG:674) healthy profit numbers didn't contain any surprises for investors. However the statutory profit number doesn't tell the whole story, and we have found some factors which might be of concern to shareholders.

Check out our latest analysis for China Tangshang Holdings

Examining Cashflow Against China Tangshang Holdings' 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. The ratio shows us how much a company's profit exceeds its FCF.

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".

China Tangshang Holdings has an accrual ratio of 0.29 for the year to September 2023. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Even though it reported a profit of HK$53.2m, a look at free cash flow indicates it actually burnt through HK$143m in the last year. It's worth noting that China Tangshang Holdings generated positive FCF of HK$497m a year ago, so at least they've done it in the past. However, that's not the end of the story. We must also consider the impact of unusual items on statutory profit (and thus the accrual ratio), as well as note the ramifications of the company issuing new shares. One positive for China Tangshang Holdings shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. As a result, some shareholders may be looking for stronger cash conversion in the current year.

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

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. In fact, China Tangshang Holdings increased the number of shares on issue by 18% over the last twelve months by issuing new shares. Therefore, each share now receives a smaller portion of profit. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. Check out China Tangshang Holdings' historical EPS growth by clicking on this link.

A Look At The Impact Of China Tangshang Holdings' Dilution On Its Earnings Per Share (EPS)

China Tangshang Holdings was losing money three years ago. The good news is that profit was up 9.5% in the last twelve months. But earnings per share are actually down 16%, over that same period. This shows how dangerous it is to rely on net income alone, when measuring growth. So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, if China Tangshang Holdings' earnings per share can increase, then the share price should too. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

How Do Unusual Items Influence Profit?

China Tangshang Holdings' profit suffered from unusual items, which reduced profit by HK$45m in the last twelve months. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect China Tangshang Holdings to produce a higher profit next year, all else being equal.

Our Take On China Tangshang Holdings' Profit Performance

In conclusion, China Tangshang Holdings' accrual ratio suggests that its statutory earnings are not backed by cash flow; but the fact unusual items actually weighed on profit may create upside if those unusual items to not recur. On top of that, the dilution means that shareholders now own less of the company. Based on these factors, we think that China Tangshang Holdings' statutory profits probably make it seem better than it is on an underlying level. So while earnings quality is important, it's equally important to consider the risks facing China Tangshang Holdings at this point in time. Our analysis shows 4 warning signs for China Tangshang Holdings (1 makes us a bit uncomfortable!) and we strongly recommend you look at these before investing.

Our examination of China Tangshang Holdings 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 that insiders are buying.

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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.