CSSC Offshore & Marine Engineering (Group) Company Limited's (HKG:317) stock was strong despite it releasing a soft earnings report last week. We think that investors might be looking at some positive factors beyond the earnings numbers.
A Closer Look At CSSC Offshore & Marine Engineering (Group)'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'.
As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".
CSSC Offshore & Marine Engineering (Group) has an accrual ratio of -0.29 for the year to December 2023. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of CN¥2.8b during the period, dwarfing its reported profit of CN¥48.1m. CSSC Offshore & Marine Engineering (Group) shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.
Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of CSSC Offshore & Marine Engineering (Group).
How Do Unusual Items Influence Profit?
Surprisingly, given CSSC Offshore & Marine Engineering (Group)'s accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥45m in unusual items. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. Which is hardly surprising, given the name. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).
Our Take On CSSC Offshore & Marine Engineering (Group)'s Profit Performance
In conclusion, CSSC Offshore & Marine Engineering (Group)'s accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Based on these factors, we think that CSSC Offshore & Marine Engineering (Group)'s profits are a reasonably conservative guide to its underlying profitability. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Case in point: We've spotted 2 warning signs for CSSC Offshore & Marine Engineering (Group) you should be aware of.
In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. But there are plenty of other ways to inform your opinion of a company. 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. 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.