We're Not Counting On China Gingko Education Group (HKG:1851) To Sustain Its Statutory Profitability

As a general rule, we think profitable companies are less risky than companies that lose money. That said, the current statutory profit is not always a good guide to a company's underlying profitability. Today we'll focus on whether this year's statutory profits are a good guide to understanding China Gingko Education Group (HKG:1851).

While China Gingko Education Group was able to generate revenue of CN¥162.9m in the last twelve months, we think its profit result of CN¥29.9m was more important. As you can see in the chart below, its profit has declined over the last three years, even though its revenue has increased.

View our latest analysis for China Gingko Education 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. So today we'll look at what China Gingko Education Group's cashflow and unusual items tell us about the quality of its earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of China Gingko Education Group.

Zooming In On China Gingko Education 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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

China Gingko Education Group has an accrual ratio of 0.48 for the year to June 2020. 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 CN¥283m, in contrast to the aforementioned profit of CN¥29.9m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥283m, this year, indicates high risk. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥6.0m, 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. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And that's as you'd expect, given these boosts are described as 'unusual'. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On China Gingko Education Group's Profit Performance

Summing up, China Gingko Education Group received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For the reasons mentioned above, we think that a perfunctory glance at China Gingko Education Group's statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into China Gingko Education Group, you'd also look into what risks it is currently facing. For instance, we've identified 4 warning signs for China Gingko Education Group (3 are a bit unpleasant) you should be familiar with.

Our examination of China Gingko Education 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. 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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