Shareholders appeared unconcerned with Hengbao Co.,Ltd.'s (SZSE:002104) lackluster earnings report last week. Our analysis suggests that while the profits are soft, the foundations of the business are strong.

A Closer Look At HengbaoLtd'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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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".

For the year to June 2024, HengbaoLtd had an accrual ratio of -0.11. Therefore, its statutory earnings were quite a lot less than its free cashflow. In fact, it had free cash flow of CN¥239m in the last year, which was a lot more than its statutory profit of CN¥122.8m. HengbaoLtd's free cash flow improved over the last year, which is generally good to see.

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

Our Take On HengbaoLtd's Profit Performance

HengbaoLtd's accrual ratio is solid, and indicates strong free cash flow, as we discussed, above. Because of this, we think HengbaoLtd's earnings potential is at least as good as it seems, and maybe even better! On the other hand, its EPS actually shrunk in the last twelve months. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example, we've discovered 1 warning sign that you should run your eye over to get a better picture of HengbaoLtd.

Today we've zoomed in on a single data point to better understand the nature of HengbaoLtd's profit. 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 with significant insider holdings 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.