Zhongzhi Pharmaceutical Holdings (HKG:3737) Strong Profits May Be Masking Some Underlying Issues

The market for Zhongzhi Pharmaceutical Holdings Limited's (HKG:3737) stock was strong after it released a healthy earnings report last week. However, we think that shareholders should be cautious as we found some worrying factors underlying the profit.

View our latest analysis for Zhongzhi Pharmaceutical Holdings

Examining Cashflow Against Zhongzhi Pharmaceutical Holdings' Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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.

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. 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 December 2020, Zhongzhi Pharmaceutical Holdings recorded 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. Even though it reported a profit of CN¥138.5m, a look at free cash flow indicates it actually burnt through CN¥25m in the last year. We saw that FCF was CN¥102m a year ago though, so Zhongzhi Pharmaceutical Holdings has at least been able to generate positive FCF in the past.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zhongzhi Pharmaceutical Holdings.

Our Take On Zhongzhi Pharmaceutical Holdings' Profit Performance

As we discussed above, we think Zhongzhi Pharmaceutical Holdings' earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that Zhongzhi Pharmaceutical Holdings' statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But the good news is that its EPS growth over the last three years has been very impressive. 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. If you want to do dive deeper into Zhongzhi Pharmaceutical Holdings, you'd also look into what risks it is currently facing. Be aware that Zhongzhi Pharmaceutical Holdings is showing 2 warning signs in our investment analysis and 1 of those can't be ignored...

This note has only looked at a single factor that sheds light on the nature of Zhongzhi Pharmaceutical Holdings' profit. 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. 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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