Does China Hanking Holdings's (HKG:3788) Statutory Profit Adequately Reflect Its Underlying Profit?

As a general rule, we think profitable companies are less risky than companies that lose money. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. In this article, we'll look at how useful this year's statutory profit is, when analysing China Hanking Holdings (HKG:3788).

It's good to see that over the last twelve months China Hanking Holdings made a profit of CN¥357.4m on revenue of CN¥2.23b. The good news is that the company managed to grow its revenue over the last three years, and also move from loss-making to profitable.

View our latest analysis for China Hanking Holdings

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. So today we'll look at what China Hanking Holdings' 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 China Hanking Holdings.

Examining Cashflow Against China Hanking 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). 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. The ratio shows us how much a company's profit exceeds its FCF.

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 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

China Hanking Holdings has an accrual ratio of -0.15 for the year to June 2020. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of CN¥559m, well over the CN¥357.4m it reported in profit. China Hanking Holdings' free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons.

Our Take On China Hanking Holdings' Profit Performance

As we discussed above, China Hanking Holdings has perfectly satisfactory free cash flow relative to profit. Based on this observation, we consider it likely that China Hanking Holdings' statutory profit actually understates its earnings potential! And on top of that, its earnings per share increased by 19% in the last year. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Case in point: We've spotted 3 warning signs for China Hanking Holdings you should be aware of.

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