Ajisen (China) Holdings' (HKG:538) Conservative Accounting Might Explain Soft Earnings

The market for Ajisen (China) Holdings Limited's (HKG:538) shares didn't move much after it posted weak earnings recently. We think that the softer headline numbers might be getting counterbalanced by some positive underlying factors.

View our latest analysis for Ajisen (China) Holdings

Examining Cashflow Against Ajisen (China) Holdings' Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. 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 June 2024, Ajisen (China) Holdings recorded an accrual ratio of -0.21. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of CN¥333m, well over the CN¥40.9m it reported in profit. Ajisen (China) Holdings' free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Ajisen (China) Holdings.

The Impact Of Unusual Items On Profit

Ajisen (China) Holdings' profit was reduced by unusual items worth CN¥104m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. In the twelve months to June 2024, Ajisen (China) Holdings had a big unusual items expense. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.

Our Take On Ajisen (China) Holdings' Profit Performance

Considering both Ajisen (China) Holdings' accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. After considering all this, we reckon Ajisen (China) Holdings' statutory profit probably understates its earnings potential! Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. To that end, you should learn about the 4 warning signs we've spotted with Ajisen (China) Holdings (including 1 which is concerning).

After our examination into the nature of Ajisen (China) Holdings' profit, we've come away optimistic for the company. 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. 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 with significant insider holdings to be useful.

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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.