The subdued market reaction suggests that Hunan Heshun Petroleum Co.,Ltd.'s (SHSE:603353) recent earnings didn't contain any surprises. We think that investors are worried about some weaknesses underlying the earnings.

Examining Cashflow Against Hunan Heshun PetroleumLtd's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. 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. 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 September 2023, Hunan Heshun PetroleumLtd had an accrual ratio of -0.12. Therefore, its statutory earnings were quite a lot less than its free cashflow. In fact, it had free cash flow of CN¥220m in the last year, which was a lot more than its statutory profit of CN¥68.0m. Hunan Heshun PetroleumLtd's free cash flow improved over the last year, which is generally good to see. 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.

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

How Do Unusual Items Influence Profit?

Surprisingly, given Hunan Heshun PetroleumLtd's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥13m in unusual items. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. If Hunan Heshun PetroleumLtd 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 Hunan Heshun PetroleumLtd's Profit Performance

Hunan Heshun PetroleumLtd's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Based on these factors, it's hard to tell if Hunan Heshun PetroleumLtd's profits are a reasonable reflection of its underlying profitability. If you want to do dive deeper into Hunan Heshun PetroleumLtd, you'd also look into what risks it is currently facing. Our analysis shows 2 warning signs for Hunan Heshun PetroleumLtd (1 can't be ignored!) and we strongly recommend you look at them before investing.

Our examination of Hunan Heshun PetroleumLtd has focussed on certain factors that can make its earnings look better than they are. But there are plenty of other ways to inform your opinion of a company. 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.