Investors Shouldn't Be Too Comfortable With Ko Yo Chemical (Group)'s (HKG:827) Robust Earnings

Ko Yo Chemical (Group) Limited (HKG:827) announced strong profits, but the stock was stagnant. We did some digging, and we found some concerning factors in the details.

See our latest analysis for Ko Yo Chemical (Group)

Examining Cashflow Against Ko Yo Chemical (Group)'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). 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. 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 2021, Ko Yo Chemical (Group) had an accrual ratio of 0.24. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Over the last year it actually had negative free cash flow of CN¥228m, in contrast to the aforementioned profit of CN¥379.2m. We also note that Ko Yo Chemical (Group)'s free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥228m. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part. One positive for Ko Yo Chemical (Group) shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Ko Yo Chemical (Group).

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥115m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And that's as you'd expect, given these boosts are described as 'unusual'. If Ko Yo Chemical (Group) doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Ko Yo Chemical (Group)'s Profit Performance

Ko Yo Chemical (Group) 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 Ko Yo Chemical (Group)'s statutory profits might make it look better than it really is on an underlying level. So while earnings quality is important, it's equally important to consider the risks facing Ko Yo Chemical (Group) at this point in time. Be aware that Ko Yo Chemical (Group) is showing 4 warning signs in our investment analysis and 2 of those are a bit concerning...

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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. 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.