The market was pleased with the recent earnings report from Hubei Hongyuan Pharmaceutical Technology Co., Ltd. (SZSE:301246), despite the profit numbers being soft. However, we think the company is showing some signs that things are more promising than they seem.

Zooming In On Hubei Hongyuan Pharmaceutical Technology's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. The ratio shows us how much a company's profit exceeds its FCF.

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. 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, Hubei Hongyuan Pharmaceutical Technology had an accrual ratio of 0.24. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Over the last year it actually had negative free cash flow of CN¥548m, in contrast to the aforementioned profit of CN¥53.6m. We also note that Hubei Hongyuan Pharmaceutical 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¥548m. However, that's not all there is to consider. 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 Hubei Hongyuan Pharmaceutical Technology.

How Do Unusual Items Influence Profit?

Hubei Hongyuan Pharmaceutical Technology's profit suffered from unusual items, which reduced profit by CN¥14m in the last twelve months. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. 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. If Hubei Hongyuan Pharmaceutical Technology doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On Hubei Hongyuan Pharmaceutical Technology's Profit Performance

In conclusion, Hubei Hongyuan Pharmaceutical Technology's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Based on these factors, it's hard to tell if Hubei Hongyuan Pharmaceutical Technology's profits are a reasonable reflection of its underlying profitability. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. To that end, you should learn about the 2 warning signs we've spotted with Hubei Hongyuan Pharmaceutical Technology (including 1 which doesn't sit too well with us).

Our examination of Hubei Hongyuan Pharmaceutical Technology has focussed on certain factors that can make its earnings look better than they are. 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.