Following the release of a positive earnings report recently, Hangzhou Alltest Biotech Co., Ltd.'s (SHSE:688606) stock performed well. Despite this, we feel that there are some reasons to be cautious with these earnings.

Zooming In On Hangzhou Alltest Biotech'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). 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. While having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to June 2024, Hangzhou Alltest Biotech recorded an accrual ratio of 0.39. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of CN¥147m, in contrast to the aforementioned profit of CN¥233.3m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥147m, this year, indicates high risk. 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.

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

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Hangzhou Alltest Biotech's profit was boosted by unusual items worth CN¥44m in the last twelve months. 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. And that's as you'd expect, given these boosts are described as 'unusual'. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Hangzhou Alltest Biotech's Profit Performance

Hangzhou Alltest Biotech 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 Hangzhou Alltest Biotech's statutory profits might make it look better than it really is on an underlying level. If you'd like to know more about Hangzhou Alltest Biotech as a business, it's important to be aware of any risks it's facing. For instance, we've identified 3 warning signs for Hangzhou Alltest Biotech (2 can't be ignored) you should be familiar with.

Our examination of Hangzhou Alltest Biotech has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks with high insider ownership.

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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.