YiChang HEC ChangJiang Pharmaceutical (HKG:1558) Strong Profits May Be Masking Some Underlying Issues

YiChang HEC ChangJiang Pharmaceutical Co., Ltd.'s (HKG:1558) healthy profit numbers didn't contain any surprises for investors. However the statutory profit number doesn't tell the whole story, and we have found some factors which might be of concern to shareholders.

View our latest analysis for YiChang HEC ChangJiang Pharmaceutical

A Closer Look At YiChang HEC ChangJiang Pharmaceutical'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. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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

Over the twelve months to June 2024, YiChang HEC ChangJiang Pharmaceutical recorded an accrual ratio of 0.24. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Even though it reported a profit of CN¥1.65b, a look at free cash flow indicates it actually burnt through CN¥398m in the last year. It's worth noting that YiChang HEC ChangJiang Pharmaceutical generated positive FCF of CN¥2.1b a year ago, so at least they've done it in the past. 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 YiChang HEC ChangJiang Pharmaceutical 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.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) YiChang HEC ChangJiang Pharmaceutical saw its profit reduced by unusual items worth CN¥422m. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. Assuming those unusual expenses don't come up again, we'd therefore expect YiChang HEC ChangJiang Pharmaceutical to produce a higher profit next year, all else being equal.

Our Take On YiChang HEC ChangJiang Pharmaceutical's Profit Performance

In conclusion, YiChang HEC ChangJiang Pharmaceutical's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Given the contrasting considerations, we don't have a strong view as to whether YiChang HEC ChangJiang Pharmaceutical's profits are an apt reflection of its underlying potential for profit. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example - YiChang HEC ChangJiang Pharmaceutical has 2 warning signs we think you should be aware of.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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 with high insider ownership.

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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.