There May Be Reason For Hope In Modern Chinese Medicine Group's (HKG:1643) Disappointing Earnings

Investors were disappointed with the weak earnings posted by Modern Chinese Medicine Group Co., Ltd. (HKG:1643 ). Despite the soft profit numbers, our analysis has optimistic about the overall quality of the income statement.

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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. 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. While having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. 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 December 2024, Modern Chinese Medicine Group recorded an accrual ratio of 0.29. 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. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥55m despite its profit of CN¥9.67m, mentioned above. We saw that FCF was CN¥3.4m a year ago though, so Modern Chinese Medicine Group has at least been able to generate positive FCF in the past. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

See our latest analysis for Modern Chinese Medicine Group

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Modern Chinese Medicine Group.

How Do Unusual Items Influence Profit?

Modern Chinese Medicine Group's profit suffered from unusual items, which reduced profit by CN¥8.6m in the last twelve months. 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. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. 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 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

In conclusion, Modern Chinese Medicine Group's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Based on these factors, it's hard to tell if Modern Chinese Medicine Group's profits are a reasonable reflection of its underlying profitability. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Be aware that Modern Chinese Medicine Group is showing 5 warning signs in our investment analysis and 2 of those are concerning...

Our examination of Modern Chinese Medicine Group has focussed on certain factors that can make its earnings look better than they are. But there is always more to discover if you are capable of focussing your mind on minutiae. 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.