Last week's earnings announcement from Hongli Group Inc. (NASDAQ:HLP) was disappointing to investors, with a sluggish profit figure. We did some further digging and think they have a few more reasons to be concerned beyond the statutory profit.

See our latest analysis for Hongli Group

A Closer Look At Hongli Group'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. 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 June 2023, Hongli Group had an accrual ratio of 0.62. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of US$1.86m, a look at free cash flow indicates it actually burnt through US$12m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of US$12m, this year, indicates high risk.

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

Our Take On Hongli Group's Profit Performance

As we have made quite clear, we're a bit worried that Hongli Group didn't back up the last year's profit with free cashflow. As a result, we think it may well be the case that Hongli Group's underlying earnings power is lower than its statutory profit. In further bad news, its earnings per share decreased in the last year. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. To help with this, we've discovered 4 warning signs (2 are a bit concerning!) that you ought to be aware of before buying any shares in Hongli Group.

This note has only looked at a single factor that sheds light on the nature of Hongli Group's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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.