Does China Leon Inspection Holding's (HKG:1586) Statutory Profit Adequately Reflect Its Underlying Profit?

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. This article will consider whether China Leon Inspection Holding's (HKG:1586) statutory profits are a good guide to its underlying earnings.

We like the fact that China Leon Inspection Holding made a profit of CN¥32.1m on its revenue of CN¥466.7m, in the last year. While it managed to grow its revenue over the last three years, its profit has moved in the other direction, as you can see in the chart below.

View our latest analysis for China Leon Inspection Holding

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. As a result, we think it's well worth considering what China Leon Inspection Holding's cashflow (when compared to its earnings) can tell us about the nature of its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of China Leon Inspection Holding.

Examining Cashflow Against China Leon Inspection Holding'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. 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. 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".

Over the twelve months to June 2020, China Leon Inspection Holding recorded an accrual ratio of -0.14. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of CN¥62m in the last year, which was a lot more than its statutory profit of CN¥32.1m. Given that China Leon Inspection Holding had negative free cash flow in the prior corresponding period, the trailing twelve month resul of CN¥62m would seem to be a step in the right direction.

Our Take On China Leon Inspection Holding's Profit Performance

As we discussed above, China Leon Inspection Holding has perfectly satisfactory free cash flow relative to profit. Because of this, we think China Leon Inspection Holding's earnings potential is at least as good as it seems, and maybe even better! And on top of that, its earnings per share have grown at an extremely impressive rate over the last year. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So while earnings quality is important, it's equally important to consider the risks facing China Leon Inspection Holding at this point in time. Be aware that China Leon Inspection Holding is showing 3 warning signs in our investment analysis and 1 of those doesn't sit too well with us...

This note has only looked at a single factor that sheds light on the nature of China Leon Inspection Holding's profit. 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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