As a general rule, we think profitable companies are less risky than companies that lose money. 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. This article will consider whether China Investments Holdings' (HKG:132) statutory profits are a good guide to its underlying earnings.
We like the fact that China Investments Holdings made a profit of HK$22.7m on its revenue of HK$197.4m, in the last year. We know some investors love those high revenue growth stocks, but we do like to look at profit, even if it is, perhaps, a bit old fashioned. In the chart below, you can see that its profit and revenue have both grown over the last three years, although its profit has slipped in the last twelve months.
Not all profits are equal, and we can learn more about the nature of a company's past profitability by diving deeper into the financial statements. As a result, today we're going to take a closer look at China Investments Holdings' cashflow, and unusual items, with a view to understanding what these might tell us about its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of China Investments Holdings.
A Closer Look At China Investments 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. 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.
As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. While having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".
Over the twelve months to June 2020, China Investments Holdings recorded an accrual ratio of 0.36. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of HK$990m, in contrast to the aforementioned profit of HK$22.7m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of HK$990m, this year, indicates high risk. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.
The Impact Of Unusual Items On Profit
Given the accrual ratio, it's not overly surprising that China Investments Holdings' profit was boosted by unusual items worth HK$74m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. Which is hardly surprising, given the name. We can see that China Investments Holdings' positive unusual items were quite significant relative to its profit in the year to June 2020. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.
Our Take On China Investments Holdings' Profit Performance
China Investments Holdings had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue China Investments Holdings' profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about China Investments Holdings as a business, it's important to be aware of any risks it's facing. For instance, we've identified 3 warning signs for China Investments Holdings (2 make us uncomfortable) you should be familiar with.
In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. But there are plenty of other ways to inform your opinion of a company. 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 that insiders are buying.
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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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