We Wouldn't Rely On China Petrochemical Development's (TPE:1314) Statutory Earnings As A Guide

Statistically speaking, it is less risky to invest in profitable companies than in 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. In this article, we'll look at how useful this year's statutory profit is, when analysing China Petrochemical Development (TPE:1314).

It's good to see that over the last twelve months China Petrochemical Development made a profit of NT$656.2m on revenue of NT$18.2b. The chart below shows that both revenue and profit have declined over the last three years.

See our latest analysis for China Petrochemical Development

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. As a result, today we're going to take a closer look at China Petrochemical Development's cashflow, and unusual items, with a view to understanding what these might tell us about its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of China Petrochemical Development.

Examining Cashflow Against China Petrochemical Development'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

China Petrochemical Development has an accrual ratio of 0.22 for the year to September 2020. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Over the last year it actually had negative free cash flow of NT$16b, in contrast to the aforementioned profit of NT$656.2m. We also note that China Petrochemical Development's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of NT$16b. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that China Petrochemical Development's profit was boosted by unusual items worth NT$2.0b in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. China Petrochemical Development had a rather significant contribution from unusual items relative to its profit to September 2020. 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 Petrochemical Development's Profit Performance

China Petrochemical Development had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue China Petrochemical Development's profits probably give an overly generous impression of its sustainable level of profitability. 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 2 warning signs we've spotted with China Petrochemical Development (including 1 which is significant).

Our examination of China Petrochemical Development 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. 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.

When trading China Petrochemical Development or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

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