Are Kunming Dianchi Water Treatment's (HKG:3768) Statutory Earnings A Good Reflection Of Its Earnings Potential?

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. 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. Today we'll focus on whether this year's statutory profits are a good guide to understanding Kunming Dianchi Water Treatment (HKG:3768).

While Kunming Dianchi Water Treatment was able to generate revenue of CN¥1.92b in the last twelve months, we think its profit result of CN¥378.5m was more important. One positive is that it has grown both its profit and its revenue, over the last few years.

Check out our latest analysis for Kunming Dianchi Water Treatment

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. As a result, we think it's well worth considering what Kunming Dianchi Water Treatment's cashflow (when compared to its earnings) can tell us about the nature of its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Kunming Dianchi Water Treatment.

Zooming In On Kunming Dianchi Water Treatment'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. 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. 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. 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".

Over the twelve months to June 2020, Kunming Dianchi Water Treatment recorded an accrual ratio of 0.23. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Even though it reported a profit of CN¥378.5m, a look at free cash flow indicates it actually burnt through CN¥1.2b in the last year. We also note that Kunming Dianchi Water Treatment's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥1.2b.

Our Take On Kunming Dianchi Water Treatment's Profit Performance

Kunming Dianchi Water Treatment's accrual ratio for the last twelve months signifies cash conversion is less than ideal, which is a negative when it comes to our view of its earnings. Because of this, we think that it may be that Kunming Dianchi Water Treatment's statutory profits are better than its underlying earnings power. The good news is that its earnings per share increased slightly in the last year. 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. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. To that end, you should learn about the 3 warning signs we've spotted with Kunming Dianchi Water Treatment (including 2 which are significant).

This note has only looked at a single factor that sheds light on the nature of Kunming Dianchi Water Treatment'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 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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