Even though Ajisen (China) Holdings Limited's (HKG:538) recent earnings release was robust, the market didn't seem to notice. Our analysis suggests that investors might be missing some promising details.

Check out our latest analysis for Ajisen (China) Holdings

Examining Cashflow Against Ajisen (China) Holdings' 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. 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. 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".

Over the twelve months to December 2021, Ajisen (China) Holdings recorded an accrual ratio of -0.16. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of CN¥296m in the last year, which was a lot more than its statutory profit of CN¥20.9m. Ajisen (China) Holdings' free cash flow improved over the last year, which is generally good to see. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

The Impact Of Unusual Items On Profit

Ajisen (China) Holdings' profit was reduced by unusual items worth CN¥45m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. 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. In the twelve months to December 2021, Ajisen (China) Holdings had a big unusual items expense. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.

Our Take On Ajisen (China) Holdings' Profit Performance

In conclusion, both Ajisen (China) Holdings' accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Based on these factors, we think Ajisen (China) Holdings' underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! So while earnings quality is important, it's equally important to consider the risks facing Ajisen (China) Holdings at this point in time. Our analysis shows 3 warning signs for Ajisen (China) Holdings (1 shouldn't be ignored!) and we strongly recommend you look at them before investing.

After our examination into the nature of Ajisen (China) Holdings' profit, we've come away optimistic for the company. But there is always more to discover if you are capable of focussing your mind on minutiae. 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.

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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.