We're Not So Sure You Should Rely on Lansen Pharmaceutical Holdings's (HKG:503) Statutory Earnings

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. This article will consider whether Lansen Pharmaceutical Holdings' (HKG:503) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Lansen Pharmaceutical Holdings made a profit of US$110.0m on revenue of US$54.9m.

See our latest analysis for Lansen Pharmaceutical Holdings

Not all profits are equal, and we can learn more about the nature of a company's past profitability by diving deeper into the financial statements. So today we'll look at what Lansen Pharmaceutical Holdings' cashflow and unusual items tell us about the quality of its earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Lansen Pharmaceutical Holdings.

A Closer Look At Lansen Pharmaceutical Holdings' Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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.

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

Over the twelve months to June 2020, Lansen Pharmaceutical Holdings recorded an accrual ratio of 0.72. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. To wit, it produced free cash flow of US$11m during the period, falling well short of its reported profit of US$110.0m. Notably, Lansen Pharmaceutical Holdings had negative free cash flow last year, so the US$11m it produced this year was a welcome improvement. 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. One positive for Lansen Pharmaceutical Holdings 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. As a result, some shareholders may be looking for stronger cash conversion in the current year.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by US$112m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And that's as you'd expect, given these boosts are described as 'unusual'. Lansen Pharmaceutical Holdings had a rather significant contribution from unusual items relative to its profit to June 2020. 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 Lansen Pharmaceutical Holdings' Profit Performance

Lansen Pharmaceutical Holdings had a weak accrual ratio, but its profit did receive a boost from unusual items. For all the reasons mentioned above, we think that, at a glance, Lansen Pharmaceutical Holdings' statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. So while earnings quality is important, it's equally important to consider the risks facing Lansen Pharmaceutical Holdings at this point in time. For example, Lansen Pharmaceutical Holdings has 4 warning signs (and 1 which is potentially serious) we think you should know about.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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. 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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