Statutory Earnings May Not Be The Best Way To Understand China Tobacco International (HK)'s (HKG:6055) True Position

Despite posting strong earnings, China Tobacco International (HK) Company Limited's (HKG:6055) stock didn't move much over the last week. We looked deeper into the numbers and found that shareholders might be concerned with some underlying weaknesses.

See our latest analysis for China Tobacco International (HK)

Examining Cashflow Against China Tobacco International (HK)'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. 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. 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. 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 December 2021, China Tobacco International (HK) recorded an accrual ratio of 0.84. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. In the last twelve months it actually had negative free cash flow, with an outflow of HK$25m despite its profit of HK$702.8m, mentioned above. We also note that China Tobacco International (HK)'s free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of HK$25m. 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.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by HK$406m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. 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, after all, that's exactly what the accounting terminology implies. China Tobacco International (HK) had a rather significant contribution from unusual items relative to its profit to December 2021. 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 China Tobacco International (HK)'s Profit Performance

China Tobacco International (HK) 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, China Tobacco International (HK)'s statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example - China Tobacco International (HK) has 2 warning signs we think you should be aware of.

Our examination of China Tobacco International (HK) 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 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. 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.