Huaxi Holdings's (HKG:1689) Earnings Are Growing But Is There More To The Story?

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. That said, the current statutory profit is not always a good guide to a company's underlying profitability. This article will consider whether Huaxi Holdings' (HKG:1689) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Huaxi Holdings made a profit of HK$128.9m on revenue of HK$502.0m. Happily, it has grown both its profit and revenue over the last three years, as you can see in the chart below.

Check out our latest analysis for Huaxi Holdings

Importantly, statutory profits are not always the best tool for understanding a company's true earnings power, so it's well worth examining profits in a little more detail. Today, we'll discuss Huaxi Holdings' free cashflow relative to its earnings, and consider what that tells us about the company. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Huaxi Holdings.

Examining Cashflow Against Huaxi 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.

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

Huaxi Holdings has an accrual ratio of 0.61 for the year to June 2020. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. In fact, it had free cash flow of HK$17m in the last year, which was a lot less than its statutory profit of HK$128.9m. Huaxi Holdings shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months. One positive for Huaxi Holdings shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Our Take On Huaxi Holdings' Profit Performance

As we have made quite clear, we're a bit worried that Huaxi 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 Huaxi Holdings' underlying earnings power is lower than its statutory profit. But the good news is that its EPS growth over the last three years has been very impressive. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. To that end, you should learn about the 3 warning signs we've spotted with Huaxi Holdings (including 1 which is potentially serious).

Today we've zoomed in on a single data point to better understand the nature of Huaxi 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. 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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