Highbroad Advanced Material (Hefei) Co., Ltd.'s (SZSE:301321) robust earnings report didn't manage to move the market for its stock. We did some digging, and we found some concerning factors in the details.

A Closer Look At Highbroad Advanced Material (Hefei)'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. The ratio shows us how much a company's profit exceeds its FCF.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to March 2024, Highbroad Advanced Material (Hefei) had an accrual ratio of 0.32. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥604m despite its profit of CN¥34.9m, mentioned above. We also note that Highbroad Advanced Material (Hefei)'s free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥604m. 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 Highbroad Advanced Material (Hefei).

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) Highbroad Advanced Material (Hefei) saw its profit reduced by unusual items worth CN¥55m. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. 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 that's hardly a surprise given these line items are considered unusual. In the twelve months to March 2024, Highbroad Advanced Material (Hefei) 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.

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that Highbroad Advanced Material (Hefei) received a tax benefit of CN¥5.5m. 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! The receipt of a tax benefit is obviously a good thing, on its own. And since it previously lost money, it may well simply indicate the realisation of past tax losses. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. 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. While we think it's good that the company has booked a tax benefit, it does mean that there's every chance the statutory profit will come in a lot higher than it would be if the income was adjusted for one-off factors.

Our Take On Highbroad Advanced Material (Hefei)'s Profit Performance

In conclusion, Highbroad Advanced Material (Hefei)'s accrual ratio suggests that its statutory earnings are not backed by cash flow, in part due to the tax benefit it received; but the fact unusual items actually weighed on profit may create upside if those unusual items do not recur. Having considered these factors, we don't think Highbroad Advanced Material (Hefei)'s statutory profits give an overly harsh view of the business. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Every company has risks, and we've spotted 5 warning signs for Highbroad Advanced Material (Hefei) you should know about.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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.

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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.