Following the solid earnings report from Huarong Chemical Co., Ltd. (SZSE:301256), the market responded by bidding up the stock price. However, we think that shareholders should be cautious as we found some worrying factors underlying the profit.

Zooming In On Huarong Chemical'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. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. 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 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Huarong Chemical has an accrual ratio of 0.35 for the year to December 2023. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥10m despite its profit of CN¥138.7m, mentioned above. It's worth noting that Huarong Chemical generated positive FCF of CN¥81m a year ago, so at least they've done it in the past.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Huarong Chemical.

Our Take On Huarong Chemical's Profit Performance

As we have made quite clear, we're a bit worried that Huarong Chemical didn't back up the last year's profit with free cashflow. As a result, we think it may well be the case that Huarong Chemical's underlying earnings power is lower than its statutory profit. The good news is that, its earnings per share increased by 7.5% in the last year. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. If you'd like to know more about Huarong Chemical as a business, it's important to be aware of any risks it's facing. For example, Huarong Chemical has 2 warning signs (and 1 which is a bit unpleasant) we think you should know about.

Today we've zoomed in on a single data point to better understand the nature of Huarong Chemical'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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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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.