Despite Hongcheng Environmental Technology Company Limited's (HKG:2265) recent earnings report having lackluster headline numbers, the market responded positively. We think that shareholders might be missing some concerning factors that our analysis found.

Check out our latest analysis for Hongcheng Environmental Technology

Examining Cashflow Against Hongcheng Environmental Technology'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. 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.

Hongcheng Environmental Technology has an accrual ratio of 0.33 for the year to June 2023. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Even though it reported a profit of CN¥45.8m, a look at free cash flow indicates it actually burnt through CN¥94m in the last year. We also note that Hongcheng Environmental Technology's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥94m.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Hongcheng Environmental Technology.

Our Take On Hongcheng Environmental Technology's Profit Performance

As we have made quite clear, we're a bit worried that Hongcheng Environmental Technology didn't back up the last year's profit with free cashflow. As a result, we think it may well be the case that Hongcheng Environmental Technology's underlying earnings power is lower than its statutory profit. Sadly, its EPS was down over the last twelve months. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So while earnings quality is important, it's equally important to consider the risks facing Hongcheng Environmental Technology at this point in time. You'd be interested to know, that we found 1 warning sign for Hongcheng Environmental Technology and you'll want to know about this.

Today we've zoomed in on a single data point to better understand the nature of Hongcheng Environmental Technology's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. Some people consider a high return on equity to be a good sign of a quality business. 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.