Dongguang Chemical's (HKG:1702) Conservative Accounting Might Explain Soft Earnings

The market for Dongguang Chemical Limited's (HKG:1702) shares didn't move much after it posted weak earnings recently. We think that the softer headline numbers might be getting counterbalanced by some positive underlying factors.

View our latest analysis for Dongguang Chemical

Zooming In On 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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. 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 December 2023, Dongguang Chemical had an accrual ratio of -0.11. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. Indeed, in the last twelve months it reported free cash flow of CN¥302m, well over the CN¥190.1m it reported in profit. Dongguang Chemical's free cash flow improved over the last year, which is generally good to see.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Dongguang Chemical.

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 52% per year 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 while earnings quality is important, it's equally important to consider the risks facing Dongguang Chemical at this point in time. You'd be interested to know, that we found 1 warning sign for Dongguang Chemical and you'll want to know about this.

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