We Wouldn't Rely On China Xiangtai Food's (NASDAQ:PLIN) Statutory Earnings As A Guide

Broadly speaking, profitable businesses are less risky than 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. Today we'll focus on whether this year's statutory profits are a good guide to understanding China Xiangtai Food (NASDAQ:PLIN).

We like the fact that China Xiangtai Food made a profit of US$2.61m on its revenue of US$98.9m, in the last year. Happily, it has grown both its profit and revenue over the last three years (but not in the last year), as you can see in the chart below.

See our latest analysis for China Xiangtai Food

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. Thus, we will today look at China Xiangtai Food's cashflow relative to its earnings, and consider how a tax benefit has impacted its statutory profit. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of China Xiangtai Food.

Zooming In On China Xiangtai Food'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). The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. 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 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.

Over the twelve months to December 2019, China Xiangtai Food recorded an accrual ratio of 0.23. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Over the last year it actually had negative free cash flow of US$4.5m, in contrast to the aforementioned profit of US$2.61m. We also note that China Xiangtai Food's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of US$4.5m. However, as we will discuss below, we can see that the company's accrual ratio has been impacted by its tax situation. This would partially explain why the accrual ratio was so poor.

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that China Xiangtai Food received a tax benefit of US$266k. This is meaningful because companies usually pay tax rather than receive tax benefits. The receipt of a tax benefit is obviously a good thing, on its own. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal. So while we think it's great to receive a tax benefit, it does tend to imply an increased risk that the statutory profit overstates the sustainable earnings power of the business.

Our Take On China Xiangtai Food's Profit Performance

China Xiangtai Food's accrual ratio indicates weak cashflow relative to earnings, which perhaps arises in part from the tax benefit it received this year. On top of that, the unsustainable nature of tax benefits mean that there's a chance profit may be lower next year, certainly in the absence of strong growth. Considering all this we'd argue China Xiangtai Food's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about China Xiangtai Food as a business, it's important to be aware of any risks it's facing. For example, we've found that China Xiangtai Food has 4 warning signs (2 don't sit too well with us!) that deserve your attention before going any further with your analysis.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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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