After announcing healthy earnings, Guangxi Hechi Chemical Co., Ltd's (SZSE:000953) stock rose over the last week. Despite the strong profit numbers, we believe that there are some deeper issues which investors should look into.

Zooming In On Guangxi Hechi Chemical'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. This ratio tells us how much of a company's profit is not backed by free cashflow.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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.

Guangxi Hechi Chemical has an accrual ratio of 0.48 for the year to September 2024. Statistically speaking, that's a real negative for future earnings. 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¥15m, in contrast to the aforementioned profit of CN¥71.6m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥15m, 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. One positive for Guangxi Hechi Chemical 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. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

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

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Guangxi Hechi Chemical's profit was boosted by unusual items worth CN¥88m 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 analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's as you'd expect, given these boosts are described as 'unusual'. Guangxi Hechi Chemical had a rather significant contribution from unusual items relative to its profit to September 2024. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Guangxi Hechi Chemical's Profit Performance

Summing up, Guangxi Hechi Chemical 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, Guangxi Hechi Chemical's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. So while earnings quality is important, it's equally important to consider the risks facing Guangxi Hechi Chemical at this point in time. At Simply Wall St, we found 2 warning signs for Guangxi Hechi Chemical and we think they deserve your attention.

Our examination of Guangxi Hechi Chemical 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. 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.