Zhejiang Huilong New Materials Co.,Ltd.'s (SZSE:301057) recent weak earnings report didn't cause a big stock movement. However, we believe that investors should be aware of some underlying factors which may be of concern.

View our latest analysis for Zhejiang Huilong New MaterialsLtd

Zooming In On Zhejiang Huilong New MaterialsLtd'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'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Zhejiang Huilong New MaterialsLtd has an accrual ratio of 0.22 for the year to March 2022. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Over the last year it actually had negative free cash flow of CN¥9.8m, in contrast to the aforementioned profit of CN¥69.3m. We saw that FCF was CN¥57m a year ago though, so Zhejiang Huilong New MaterialsLtd has at least been able to generate positive FCF in the past. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zhejiang Huilong New MaterialsLtd.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Zhejiang Huilong New MaterialsLtd's profit was boosted by unusual items worth CN¥8.7m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Zhejiang Huilong New MaterialsLtd's Profit Performance

Zhejiang Huilong New MaterialsLtd had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at Zhejiang Huilong New MaterialsLtd's statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into Zhejiang Huilong New MaterialsLtd, you'd also look into what risks it is currently facing. To that end, you should learn about the 2 warning signs we've spotted with Zhejiang Huilong New MaterialsLtd (including 1 which makes us a bit uncomfortable).

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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.