The recent earnings posted by DuZhe Publish&Media Co.,Ltd (SHSE:603999) were solid, but the stock didn't move as much as we expected. However the statutory profit number doesn't tell the whole story, and we have found some factors which might be of concern to shareholders.
Examining Cashflow Against DuZhe Publish&MediaLtd'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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.
For the year to December 2023, DuZhe Publish&MediaLtd had an accrual ratio of -0.12. 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¥190m in the last year, which was a lot more than its statutory profit of CN¥98.2m. DuZhe Publish&MediaLtd shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio).
Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of DuZhe Publish&MediaLtd.
The Impact Of Unusual Items On Profit
While the accrual ratio might bode well, we also note that DuZhe Publish&MediaLtd's profit was boosted by unusual items worth CN¥7.2m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. If DuZhe Publish&MediaLtd doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.
An Unusual Tax Situation
Moving on from the accrual ratio, we note that DuZhe Publish&MediaLtd profited from a tax benefit which contributed CN¥20m to profit. This is meaningful because companies usually pay tax rather than receive tax benefits. We're sure the company was pleased with its tax benefit. 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 DuZhe Publish&MediaLtd's Profit Performance
In conclusion, DuZhe Publish&MediaLtd's accrual ratio suggests its earnings are well backed by cash but its boost from unusual items, and a tax benefit, probably mean that the statutory number make the company seem more profitable than it is at an underlying level. After taking into account all the aforementioned observations we think that DuZhe Publish&MediaLtd's profits probably give a generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing DuZhe Publish&MediaLtd at this point in time. For example - DuZhe Publish&MediaLtd has 1 warning sign we think you should be aware of.
Our examination of DuZhe Publish&MediaLtd has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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 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.