Here's Why We Think Yincheng International Holding's (HKG:1902) Statutory Earnings Might Be Conservative

As a general rule, we think profitable companies are less risky than companies that lose money. 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 Yincheng International Holding's (HKG:1902) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Yincheng International Holding made a profit of CN¥246.1m on revenue of CN¥9.91b. The chart below shows how it has grown revenue over the last three years, but that profit has declined.

View our latest analysis for Yincheng International Holding

Importantly, statutory profits are not always the best tool for understanding a company's true earnings power, so it's well worth examining profits in a little more detail. Today, we'll discuss Yincheng International Holding's free cashflow relative to its earnings, and consider what that tells us about the company. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Yincheng International Holding.

A Closer Look At Yincheng International Holding's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to June 2020, Yincheng International Holding had an accrual ratio of -0.34. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of CN¥3.7b during the period, dwarfing its reported profit of CN¥246.1m. Notably, Yincheng International Holding had negative free cash flow last year, so the CN¥3.7b it produced this year was a welcome improvement.

Our Take On Yincheng International Holding's Profit Performance

As we discussed above, Yincheng International Holding's accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Based on this observation, we consider it possible that Yincheng International Holding's statutory profit actually understates its earnings potential! And the EPS is up 19% over the last twelve months. 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. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Case in point: We've spotted 2 warning signs for Yincheng International Holding you should be mindful of and 1 of these can't be ignored.

Today we've zoomed in on a single data point to better understand the nature of Yincheng International Holding's profit. But there are plenty of other ways to inform your opinion of a company. 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 that insiders are buying to be useful.

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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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