We're Not So Sure You Should Rely on Zhong An Group's (HKG:672) Statutory Earnings

Broadly speaking, profitable businesses are less risky than unprofitable ones. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. This article will consider whether Zhong An Group's (HKG:672) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Zhong An Group made a profit of CN¥612.0m on revenue of CN¥3.88b. Even though its revenue is down over the last three years, its profit has actually increased, as you can see, below.

Check out our latest analysis for Zhong An Group

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. Therefore, we think it's worth taking a closer look at Zhong An Group's cashflow, as well as examining the impact that unusual items have had on its reported profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zhong An Group.

A Closer Look At Zhong An Group's 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Zhong An Group has an accrual ratio of 0.27 for the year to June 2020. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥3.8b despite its profit of CN¥612.0m, mentioned above. We saw that FCF was CN¥725m a year ago though, so Zhong An 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. The good news for shareholders is that Zhong An Group's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Zhong An Group's profit was boosted by unusual items worth CN¥280m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's as you'd expect, given these boosts are described as 'unusual'. We can see that Zhong An Group's positive unusual items were quite significant relative to its profit in the year to June 2020. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Zhong An Group's Profit Performance

Summing up, Zhong An Group received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Zhong An Group's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Zhong An Group as a business, it's important to be aware of any risks it's facing. For instance, we've identified 3 warning signs for Zhong An Group (2 are a bit concerning) you should be familiar with.

Our examination of Zhong An Group has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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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