We Wouldn't Rely On Charmacy Pharmaceutical's (HKG:2289) Statutory Earnings As A Guide

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. 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 Charmacy Pharmaceutical's (HKG:2289) statutory profits are a good guide to its underlying earnings.

While Charmacy Pharmaceutical was able to generate revenue of CN¥3.65b in the last twelve months, we think its profit result of CN¥28.7m was more important. In the last few years both its revenue and its profit have fallen, as you can see in the chart below.

View our latest analysis for Charmacy Pharmaceutical

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. So today we'll look at what Charmacy Pharmaceutical's cashflow tells 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 Charmacy Pharmaceutical.

A Closer Look At Charmacy Pharmaceutical'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. 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.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to June 2020, Charmacy Pharmaceutical had an accrual ratio of 0.33. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥280m despite its profit of CN¥28.7m, mentioned above. It's worth noting that Charmacy Pharmaceutical generated positive FCF of CN¥6.7m a year ago, so at least they've done it in the past.

Our Take On Charmacy Pharmaceutical's Profit Performance

As we have made quite clear, we're a bit worried that Charmacy Pharmaceutical didn't back up the last year's profit with free cashflow. For this reason, we think that Charmacy Pharmaceutical's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. Sadly, its EPS was down over the last twelve months. 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 if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. To help with this, we've discovered 5 warning signs (2 don't sit too well with us!) that you ought to be aware of before buying any shares in Charmacy Pharmaceutical.

This note has only looked at a single factor that sheds light on the nature of Charmacy Pharmaceutical's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. Some people consider a high return on equity to be a good sign of a quality business. 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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