Cathay Chemical Works' (TWSE:1713) Solid Profits Have Weak Fundamentals

Cathay Chemical Works Inc.'s (TWSE:1713) stock was strong after they recently reported robust earnings. We did some analysis and think that investors are missing some details hidden beneath the profit numbers.

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Examining Cashflow Against Cathay Chemical Works' Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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.

Cathay Chemical Works has an accrual ratio of 0.50 for the year to December 2024. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. Indeed, in the last twelve months it reported free cash flow of NT$151m, which is significantly less than its profit of NT$1.56b. At this point we should mention that Cathay Chemical Works did manage to increase its free cash flow in the last twelve months

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Cathay Chemical Works.

Our Take On Cathay Chemical Works' Profit Performance

As we have made quite clear, we're a bit worried that Cathay Chemical Works didn't back up the last year's profit with free cashflow. For this reason, we think that Cathay Chemical Works' 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 Cathay Chemical Works is showing 2 warning signs in our investment analysis and 1 of those shouldn't be ignored...

This note has only looked at a single factor that sheds light on the nature of Cathay Chemical Works' 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks with high insider ownership.

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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.