Henan Jinma Energy's (HKG:6885) Profits Appear To Have Quality Issues

The recent earnings posted by Henan Jinma Energy Company Limited (HKG:6885) were solid, but the stock didn't move as much as we expected. We think this is due to investors looking beyond the statutory profits and being concerned with what they see.

See our latest analysis for Henan Jinma Energy

Examining Cashflow Against Henan Jinma Energy's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to June 2021, Henan Jinma Energy recorded an accrual ratio of 0.28. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. Even though it reported a profit of CN¥598.5m, a look at free cash flow indicates it actually burnt through CN¥210m in the last year. It's worth noting that Henan Jinma Energy generated positive FCF of CN¥129m a year ago, so at least they've done it in the past.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Henan Jinma Energy.

Our Take On Henan Jinma Energy's Profit Performance

Henan Jinma Energy's accrual ratio for the last twelve months signifies cash conversion is less than ideal, which is a negative when it comes to our view of its earnings. Because of this, we think that it may be that Henan Jinma Energy's statutory profits are better than its underlying earnings power. The good news is that, its earnings per share increased by 23% in the last year. 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. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. When we did our research, we found 3 warning signs for Henan Jinma Energy (1 is potentially serious!) that we believe deserve your full attention.

This note has only looked at a single factor that sheds light on the nature of Henan Jinma Energy's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying to be useful.

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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.
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