Investors were disappointed with HUNAN RESUN Co., Ltd.'s (SZSE:001218) earnings, despite the strong profit numbers. We did some digging and found some worrying underlying problems.

Examining Cashflow Against HUNAN RESUN's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. 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. 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 2023, HUNAN RESUN recorded an accrual ratio of 0.20. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Even though it reported a profit of CN¥135.7m, a look at free cash flow indicates it actually burnt through CN¥142m in the last year. It's worth noting that HUNAN RESUN generated positive FCF of CN¥150m a year ago, so at least they've done it in the past. The good news for shareholders is that HUNAN RESUN's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of HUNAN RESUN.

Our Take On HUNAN RESUN's Profit Performance

HUNAN RESUN's accrual ratio for the last twelve months signifies cash conversion is less than ideal, which is a negative when it comes to our view of its earnings. Therefore, it seems possible to us that HUNAN RESUN's true underlying earnings power is actually less than its statutory profit. But at least holders can take some solace from the 14% EPS growth in the 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 HUNAN RESUN at this point in time. For example, we've found that HUNAN RESUN has 4 warning signs (2 don't sit too well with us!) that deserve your attention before going any further with your analysis.

This note has only looked at a single factor that sheds light on the nature of HUNAN RESUN's profit. 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.