A lackluster earnings announcement from Huida Sanitary Ware Co., Ltd. (SHSE:603385) last week didn't sink the stock price. However, we believe that investors should be aware of some underlying factors which may be of concern.

View our latest analysis for Huida Sanitary Ware

Zooming In On Huida Sanitary Ware'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. 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 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to December 2021, Huida Sanitary Ware recorded an accrual ratio of 0.23. 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¥498m, in contrast to the aforementioned profit of CN¥235.3m. We saw that FCF was CN¥500m a year ago though, so Huida Sanitary Ware 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. The good news for shareholders is that Huida Sanitary Ware's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Huida Sanitary Ware's profit was boosted by unusual items worth CN¥40m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. 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. Which is hardly surprising, given the name. If Huida Sanitary Ware doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Huida Sanitary Ware's Profit Performance

Huida Sanitary Ware 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 Huida Sanitary Ware's statutory profits might make it look better than it really is on an underlying level. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For instance, we've identified 4 warning signs for Huida Sanitary Ware (1 is a bit concerning) you should be familiar with.

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 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.

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.