Weak Statutory Earnings May Not Tell The Whole Story For China Electronics Huada Technology (HKG:85)

The subdued market reaction suggests that China Electronics Huada Technology Company Limited's (HKG:85) recent earnings didn't contain any surprises. Our analysis suggests that along with soft profit numbers, investors should be aware of some other underlying weaknesses in the numbers.

We've found 21 US stocks that are forecast to pay a dividend yield of over 6% next year. See the full list for free.

Zooming In On China Electronics Huada Technology's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to December 2024, China Electronics Huada Technology had an accrual ratio of 0.40. Ergo, its free cash flow is significantly weaker than its profit. As a general rule, that bodes poorly for future profitability. Indeed, in the last twelve months it reported free cash flow of HK$184m, which is significantly less than its profit of HK$587.5m. China Electronics Huada Technology shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months. The good news for shareholders is that China Electronics Huada Technology'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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of China Electronics Huada Technology.

Our Take On China Electronics Huada Technology's Profit Performance

As we have made quite clear, we're a bit worried that China Electronics Huada Technology didn't back up the last year's profit with free cashflow. For this reason, we think that China Electronics Huada Technology's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But the good news is that its EPS growth over the last three years has been very impressive. 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. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Be aware that China Electronics Huada Technology is showing 2 warning signs in our investment analysis and 1 of those is a bit unpleasant...

Today we've zoomed in on a single data point to better understand the nature of China Electronics Huada Technology'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 with significant insider holdings to be useful.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.