Hunan Corun New Energy Co., Ltd.'s (SHSE:600478) weak earnings were disregarded by the market. Despite the market responding positively, we think that there are several concerning factors that investors should be aware of.

A Closer Look At Hunan Corun New Energy'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. This ratio tells us how much of a company's profit is not backed by free cashflow.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to September 2023, Hunan Corun New Energy had an accrual ratio of 0.25. 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¥1.0b, in contrast to the aforementioned profit of CN¥35.7m. It's worth noting that Hunan Corun New Energy generated positive FCF of CN¥275m a year ago, so at least they've done it in the past. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part. One positive for Hunan Corun New Energy shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. As a result, some shareholders may be looking for stronger cash conversion in the current year.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Hunan Corun New Energy.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥45m, in the last year, probably goes some way to explain why its accrual ratio was so weak. 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. And, after all, that's exactly what the accounting terminology implies. Hunan Corun New Energy had a rather significant contribution from unusual items relative to its profit to September 2023. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Hunan Corun New Energy's Profit Performance

Summing up, Hunan Corun New Energy received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For the reasons mentioned above, we think that a perfunctory glance at Hunan Corun New Energy's statutory profits might make it look better than it really is on an underlying level. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. To that end, you should learn about the 3 warning signs we've spotted with Hunan Corun New Energy (including 2 which are potentially serious).

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. 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.

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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.