Investors were underwhelmed by the solid earnings posted by Cathay Group Holdings Inc. (HKG:1981) recently. We did some digging and actually think they are being unnecessarily pessimistic.
Examining Cashflow Against Cathay Group 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). 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.
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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.
Over the twelve months to December 2024, Cathay Group Holdings recorded 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. Indeed, in the last twelve months it reported free cash flow of CN¥260m, well over the CN¥92.1m it reported in profit. Cathay Group Holdings' free cash flow improved over the last year, which is generally good to see.
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.
Our Take On Cathay Group Holdings' Profit Performance
As we discussed above, Cathay Group Holdings has perfectly satisfactory free cash flow relative to profit. Because of this, we think Cathay Group Holdings' earnings potential is at least as good as it seems, and maybe even better! And it's also positive that the company showed enough improvement to book a profit this year, after losing money last year. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So while earnings quality is important, it's equally important to consider the risks facing Cathay Group Holdings at this point in time. Our analysis shows 2 warning signs for Cathay Group Holdings (1 is a bit unpleasant!) and we strongly recommend you look at these bad boys before investing.
Today we've zoomed in on a single data point to better understand the nature of Cathay Group Holdings' profit. 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. 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.