Hunan Sundy Science and Technology Co., Ltd.'s (SZSE:300515) recent soft profit numbers didn't appear to worry shareholders, as the stock price showed strength. Our analysis suggests that investors may have noticed some promising signs beyond the statutory profit figures.

Examining Cashflow Against Hunan Sundy Science and Technology's 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. 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 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. 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 March 2024, Hunan Sundy Science and Technology recorded an accrual ratio of -0.18. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of CN¥128m in the last year, which was a lot more than its statutory profit of CN¥57.2m. Hunan Sundy Science and Technology shareholders are no doubt pleased that free cash flow improved over the last twelve months.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Hunan Sundy Science and Technology.

Our Take On Hunan Sundy Science and Technology's Profit Performance

As we discussed above, Hunan Sundy Science and Technology's accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Because of this, we think Hunan Sundy Science and Technology's underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! On the other hand, its EPS actually shrunk in the last twelve months. 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 Sundy Science and Technology at this point in time. In terms of investment risks, we've identified 3 warning signs with Hunan Sundy Science and Technology, and understanding these should be part of your investment process.

Today we've zoomed in on a single data point to better understand the nature of Hunan Sundy Science and Technology'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. 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 that insiders are buying 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.