Jia Yao Holdings' (HKG:1626) Earnings Are Of Questionable Quality

Investors were disappointed with Jia Yao Holdings Limited's (HKG:1626) earnings, despite the strong profit numbers. We think that the market might be paying attention to some underlying factors that they find to be concerning.

See our latest analysis for Jia Yao Holdings

A Closer Look At Jia Yao Holdings' Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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

Over the twelve months to December 2023, Jia Yao Holdings recorded an accrual ratio of 0.41. Ergo, its free cash flow is significantly weaker than its profit. As a general rule, that bodes poorly for future profitability. To wit, it produced free cash flow of CN¥24m during the period, falling well short of its reported profit of CN¥99.3m. Jia Yao Holdings' free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits. The good news for shareholders is that Jia Yao Holdings' accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

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

Our Take On Jia Yao Holdings' Profit Performance

As we have made quite clear, we're a bit worried that Jia Yao Holdings didn't back up the last year's profit with free cashflow. As a result, we think it may well be the case that Jia Yao Holdings' underlying earnings power is lower than its statutory profit. The silver lining is that its EPS growth over the last year has been really wonderful, even if it's not a perfect measure. 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. You'd be interested to know, that we found 1 warning sign for Jia Yao Holdings and you'll want to know about it.

Today we've zoomed in on a single data point to better understand the nature of Jia Yao Holdings' profit. But there are plenty of other ways to inform your opinion of a company. 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.