Hongmian Zhihui Science and Technology Innovation Co.,Ltd.Guangzhou's (SZSE:000523) recent earnings report didn't offer any surprises, with the shares unchanged over the last week. We did some analysis to find out why and believe that investors might be missing some encouraging factors contained in the earnings.

A Closer Look At Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou's 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. 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'.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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.

Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou has an accrual ratio of -0.20 for the year to March 2024. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of CN¥268m during the period, dwarfing its reported profit of CN¥87.0m. Given that Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou had negative free cash flow in the prior corresponding period, the trailing twelve month resul of CN¥268m would seem to be a step in the right direction. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio).

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou.

The Impact Of Unusual Items On Profit

Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou's profit was reduced by unusual items worth CN¥37m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. 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. Assuming those unusual expenses don't come up again, we'd therefore expect Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou to produce a higher profit next year, all else being equal.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou profited from a tax benefit which contributed CN¥34m to profit. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! We're sure the company was pleased with its tax benefit. And given that it lost money last year, it seems possible that the benefit is evidence that it now expects to find value in its past tax losses. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth.

Our Take On Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou's Profit Performance

In conclusion, both Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative, but the presence of a tax benefits may be inflating the numbers in a way that won't persist. Based on these factors, we think Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou's earnings potential is at least as good as it seems, and maybe even better! Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For example - Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou has 1 warning sign we think you should be aware of.

Our examination of Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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 that insiders are buying to be useful.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.