We Think You Should Be Aware Of Some Concerning Factors In Modern Chinese Medicine Group's (HKG:1643) Earnings

The recent earnings posted by Modern Chinese Medicine Group Co., Ltd. (HKG:1643) were solid, but the stock didn't move as much as we expected. We believe that shareholders have noticed some concerning factors beyond the statutory profit numbers.

See our latest analysis for Modern Chinese Medicine Group

Zooming In On Modern Chinese Medicine Group'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. 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. 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 June 2021, Modern Chinese Medicine Group recorded an accrual ratio of 0.50. Ergo, its free cash flow is significantly weaker than its profit. Statistically speaking, that's a real negative for future earnings. In fact, it had free cash flow of CN¥21m in the last year, which was a lot less than its statutory profit of CN¥67.8m. At this point we should mention that Modern Chinese Medicine Group did manage to increase its free cash flow in the last twelve months

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

Our Take On Modern Chinese Medicine Group's Profit Performance

As we discussed above, we think Modern Chinese Medicine Group's earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that Modern Chinese Medicine Group's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. The good news is that, its earnings per share increased by 31% in the last year. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. For example, Modern Chinese Medicine Group has 3 warning signs (and 1 which is a bit unpleasant) we think you should know about.

Today we've zoomed in on a single data point to better understand the nature of Modern Chinese Medicine Group's profit. 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 that insiders are buying.

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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.
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