Modern Chinese Medicine Group's (HKG:1643) Conservative Accounting Might Explain Soft Earnings

Shareholders appeared unconcerned with Modern Chinese Medicine Group Co., Ltd.'s (HKG:1643) lackluster earnings report last week. We think that the softer headline numbers might be getting counterbalanced by some positive underlying factors.

View our latest analysis for Modern Chinese Medicine Group

A Closer Look At Modern Chinese Medicine 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to June 2024, Modern Chinese Medicine Group had an accrual ratio of 0.25. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Even though it reported a profit of CN¥14.4m, a look at free cash flow indicates it actually burnt through CN¥35m in the last year. We saw that FCF was CN¥59m a year ago though, so Modern Chinese Medicine Group has at least been able to generate positive FCF in the past. 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 Modern Chinese Medicine Group.

The Impact Of Unusual Items On Profit

Unfortunately (in the short term) Modern Chinese Medicine Group saw its profit reduced by unusual items worth CN¥8.6m. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect Modern Chinese Medicine Group to produce a higher profit next year, all else being equal.

Our Take On Modern Chinese Medicine Group's Profit Performance

Modern Chinese Medicine Group saw unusual items weigh on its profit, which should have made it easier to show high cash conversion, which it did not do, according to its accrual ratio. Based on these factors, it's hard to tell if Modern Chinese Medicine Group's profits are a reasonable reflection of its underlying profitability. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. When we did our research, we found 4 warning signs for Modern Chinese Medicine Group (2 shouldn't be ignored!) that we believe deserve your full attention.

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 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 with significant insider holdings 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.