Are China Man-Made Fiber's (TPE:1718) Statutory Earnings A Good Guide To Its Underlying Profitability?

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. That said, the current statutory profit is not always a good guide to a company's underlying profitability. In this article, we'll look at how useful this year's statutory profit is, when analysing China Man-Made Fiber (TPE:1718).

While China Man-Made Fiber was able to generate revenue of NT$29.4b in the last twelve months, we think its profit result of NT$1.66b was more important.

Check out our latest analysis for China Man-Made Fiber

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 Man-Made Fiber'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 Man-Made Fiber.

Examining Cashflow Against China Man-Made Fiber's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

China Man-Made Fiber has an accrual ratio of -0.35 for the year to September 2020. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of NT$26b, well over the NT$1.66b it reported in profit. China Man-Made Fiber shareholders are no doubt pleased that free cash flow improved over the last twelve months. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

How Do Unusual Items Influence Profit?

Surprisingly, given China Man-Made Fiber's accrual ratio implied strong cash conversion, its paper profit was actually boosted by NT$2.8b in unusual items. 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 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 Man-Made Fiber had a rather significant contribution from unusual items relative to its profit to September 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 China Man-Made Fiber's Profit Performance

China Man-Made Fiber's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Given the contrasting considerations, we don't have a strong view as to whether China Man-Made Fiber's profits are an apt reflection of its underlying potential for profit. If you'd like to know more about China Man-Made Fiber as a business, it's important to be aware of any risks it's facing. When we did our research, we found 4 warning signs for China Man-Made Fiber (2 can't be ignored!) that we believe deserve your full attention.

Our examination of China Man-Made Fiber has focussed on certain factors that can make its earnings look better than they are. But there are plenty of other ways to inform your opinion of a company. 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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