China Dongxiang (Group)'s (HKG:3818) Solid Profits Have Weak Fundamentals

China Dongxiang (Group) Co., Ltd.'s (HKG:3818) stock was strong after they reported robust earnings. However, our analysis suggests that shareholders may be missing some factors that indicate the earnings result was not as good as it looked.

See our latest analysis for China Dongxiang (Group)

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

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.

Over the twelve months to March 2021, China Dongxiang (Group) recorded an accrual ratio of 0.31. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. To wit, it produced free cash flow of CN¥63m during the period, falling well short of its reported profit of CN¥1.87b. Notably, China Dongxiang (Group) had negative free cash flow last year, so the CN¥63m 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.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥284m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. 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. If China Dongxiang (Group) 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 China Dongxiang (Group)'s Profit Performance

China Dongxiang (Group) had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at China Dongxiang (Group)'s statutory profits might make it look better than it really is on an underlying level. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For example, China Dongxiang (Group) has 4 warning signs (and 2 which are a bit unpleasant) we think you should know about.

Our examination of China Dongxiang (Group) 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 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. 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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