Strong earnings weren't enough to please Jiangsu Huasheng Tianlong Photoelectric Co.,Ltd.'s (SZSE:300029) shareholders over the last week. We did some analysis and believe that they might be concerned about some weak underlying factors.

See our latest analysis for Jiangsu Huasheng Tianlong PhotoelectricLtd

A Closer Look At Jiangsu Huasheng Tianlong PhotoelectricLtd's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to June 2022, Jiangsu Huasheng Tianlong PhotoelectricLtd recorded an accrual ratio of 8.50. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Over the last year it actually had negative free cash flow of CN¥57m, in contrast to the aforementioned profit of CN¥49.8m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥57m, this year, indicates high risk. 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. The good news for shareholders is that Jiangsu Huasheng Tianlong PhotoelectricLtd'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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Jiangsu Huasheng Tianlong PhotoelectricLtd.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥39m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. 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. We can see that Jiangsu Huasheng Tianlong PhotoelectricLtd's positive unusual items were quite significant relative to its profit in the year to June 2022. 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 Jiangsu Huasheng Tianlong PhotoelectricLtd's Profit Performance

Summing up, Jiangsu Huasheng Tianlong PhotoelectricLtd received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For all the reasons mentioned above, we think that, at a glance, Jiangsu Huasheng Tianlong PhotoelectricLtd's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. If you want to do dive deeper into Jiangsu Huasheng Tianlong PhotoelectricLtd, you'd also look into what risks it is currently facing. In terms of investment risks, we've identified 2 warning signs with Jiangsu Huasheng Tianlong PhotoelectricLtd, and understanding these should be part of your investment process.

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. 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.