China BlueChemical (HKG:3983) Shareholders Should Be Cautious Despite Solid Earnings

Shareholders didn't seem to be thrilled with China BlueChemical Ltd.'s (HKG:3983) recent earnings report, despite healthy profit numbers. Our analysis suggests they may be concerned about some underlying details.

Check out our latest analysis for China BlueChemical

A Closer Look At China BlueChemical's 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. 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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.

China BlueChemical has an accrual ratio of 0.22 for the year to December 2023. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Indeed, in the last twelve months it reported free cash flow of CN¥801m, which is significantly less than its profit of CN¥2.38b. We should mention, here, that China BlueChemical free cashflow was as flat as a pancake over the last twelve months. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

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

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥943m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And that's as you'd expect, given these boosts are described as 'unusual'. China BlueChemical had a rather significant contribution from unusual items relative to its profit to December 2023. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On China BlueChemical's Profit Performance

China BlueChemical had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at China BlueChemical's statutory profits might make it look better than it really is on an underlying level. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For example, we've found that China BlueChemical has 2 warning signs (1 is concerning!) that deserve your attention before going any further with your analysis.

Our examination of China BlueChemical has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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.