Additional Considerations Required While Assessing Central China New Life's (HKG:9983) Strong Earnings

Last week's profit announcement from Central China New Life Limited (HKG:9983) was underwhelming for investors, despite headline numbers being robust. We did some digging and found some worrying underlying problems.

Our free stock report includes 3 warning signs investors should be aware of before investing in Central China New Life. Read for free now.

A Closer Look At Central China New Life'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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

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 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. 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 December 2024, Central China New Life recorded an accrual ratio of 0.31. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. Even though it reported a profit of CN¥214.6m, a look at free cash flow indicates it actually burnt through CN¥4.5m in the last year. We also note that Central China New Life's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥4.5m. One positive for Central China New Life 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Central China New Life.

Our Take On Central China New Life's Profit Performance

Central China New Life didn't convert much of its profit to free cash flow in the last year, which some investors may consider rather suboptimal. Because of this, we think that it may be that Central China New Life's statutory profits are better than its underlying earnings power. The good news is that it earned a profit in the last twelve months, despite its previous loss. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. So while earnings quality is important, it's equally important to consider the risks facing Central China New Life at this point in time. In terms of investment risks, we've identified 3 warning signs with Central China New Life, and understanding them should be part of your investment process.

Today we've zoomed in on a single data point to better understand the nature of Central China New Life'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. 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.