Are Dongguang Chemical's (HKG:1702) Statutory Earnings A Good Reflection Of Its Earnings Potential?

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. 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. Today we'll focus on whether this year's statutory profits are a good guide to understanding Dongguang Chemical (HKG:1702).

While Dongguang Chemical was able to generate revenue of CN¥2.00b in the last twelve months, we think its profit result of CN¥103.7m was more important. In the chart below, you can see that its profit and revenue have both grown over the last three years, albeit not in the last year.

View our latest analysis for Dongguang Chemical

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. So today we'll look at what Dongguang Chemical'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 Dongguang Chemical.

Examining Cashflow Against Dongguang Chemical's 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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Dongguang Chemical has an accrual ratio of -0.12 for the year to June 2020. That indicates that its free cash flow was a fair bit more than its statutory profit. Indeed, in the last twelve months it reported free cash flow of CN¥249m, well over the CN¥103.7m it reported in profit. Dongguang Chemical did see its free cash flow drop year on year, which is less than ideal, like a Simpson's episode without Groundskeeper Willie.

Our Take On Dongguang Chemical's Profit Performance

As we discussed above, Dongguang Chemical has perfectly satisfactory free cash flow relative to profit. Based on this observation, we consider it likely that Dongguang Chemical's statutory profit actually understates its earnings potential! And on top of that, its earnings per share have grown at an extremely impressive rate over the last three years. 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. Every company has risks, and we've spotted 1 warning sign for Dongguang Chemical you should know about.

This note has only looked at a single factor that sheds light on the nature of Dongguang Chemical'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. 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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