Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it’s not always clear whether statutory profits are a good guide, going forward. This article will consider whether China Ludao Technology‘s (HKG:2023) statutory profits are a good guide to its underlying earnings.
It’s good to see that over the last twelve months China Ludao Technology made a profit of CN¥23.8m on revenue of CN¥412.6m. One positive is that it has grown both its profit and its revenue, over the last few years.
Check out our latest analysis for China Ludao Technology
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 China Ludao Technology’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 China Ludao Technology.
Examining Cashflow Against China Ludao Technology’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. 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 it’s not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. To quote a 2014 paper by Lewellen and Resutek, “firms with higher accruals tend to be less profitable in the future”.
For the year to December 2019, China Ludao Technology had an accrual ratio of -0.13. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. In fact, it had free cash flow of CN¥79m in the last year, which was a lot more than its statutory profit of CN¥23.8m. Given that China Ludao Technology had negative free cash flow in the prior corresponding period, the trailing twelve month resul of CN¥79m would seem to be a step in the right direction.
Our Take On China Ludao Technology’s Profit Performance
As we discussed above, China Ludao Technology has perfectly satisfactory free cash flow relative to profit. Based on this observation, we consider it likely that China Ludao Technology’s statutory profit actually understates its earnings potential! At the end of the day, it’s essential to consider more than just the factors above, if you want to understand the company properly. In light of this, if you’d like to do more analysis on the company, it’s vital to be informed of the risks involved. For example, China Ludao Technology has 2 warning signs (and 1 which can’t be ignored) we think you should know about.
This note has only looked at a single factor that sheds light on the nature of China Ludao Technology’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. 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.
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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. Thank you for reading.