Following the solid earnings report from Hengsheng Energy Co., Ltd (SHSE:605580), the market responded by bidding up the stock price. However, we think that shareholders should be cautious as we found some worrying factors underlying the profit.

See our latest analysis for Hengsheng Energy

Zooming In On Hengsheng Energy's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. 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. 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, Hengsheng Energy had an accrual ratio of 0.35. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥151m despite its profit of CN¥141.9m, mentioned above. We saw that FCF was CN¥35m a year ago though, so Hengsheng Energy has at least been able to generate positive FCF in the past.

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

Our Take On Hengsheng Energy's Profit Performance

As we discussed above, we think Hengsheng Energy's earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that Hengsheng Energy's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. The good news is that, its earnings per share increased by 9.2% in the last year. 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 while earnings quality is important, it's equally important to consider the risks facing Hengsheng Energy at this point in time. When we did our research, we found 2 warning signs for Hengsheng Energy (1 doesn't sit too well with us!) that we believe deserve your full attention.

This note has only looked at a single factor that sheds light on the nature of Hengsheng Energy's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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 that insiders are buying.

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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.