We Believe Changmao Biochemical Engineering's (HKG:954) Earnings Are A Poor Guide For Its Profitability

Even though Changmao Biochemical Engineering Company Limited (HKG:954) posted strong earnings recently, the stock hasn't reacted in a large way. We decided to have a deeper look, and we believe that investors might be worried about several concerning factors that we found.

Check out our latest analysis for Changmao Biochemical Engineering

Zooming In On Changmao Biochemical Engineering's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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.

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.

Changmao Biochemical Engineering has an accrual ratio of 0.39 for the year to December 2021. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Over the last year it actually had negative free cash flow of CN¥184m, in contrast to the aforementioned profit of CN¥58.3m. We also note that Changmao Biochemical Engineering's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥184m. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Changmao Biochemical Engineering.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥125m, 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'. Changmao Biochemical Engineering had a rather significant contribution from unusual items relative to its profit to December 2021. 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 Changmao Biochemical Engineering's Profit Performance

Summing up, Changmao Biochemical Engineering received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Changmao Biochemical Engineering's profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Changmao Biochemical Engineering at this point in time. To help with this, we've discovered 2 warning signs (1 is significant!) that you ought to be aware of before buying any shares in Changmao Biochemical Engineering.

Our examination of Changmao Biochemical Engineering 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. 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.