Shareholders appeared to be happy with Shanghai Huide Science & Technology Co.,Ltd's (SHSE:603192) solid earnings report last week. According to our analysis of the report, the strong headline profit numbers are supported by strong earnings fundamentals.

Examining Cashflow Against Shanghai Huide Science & TechnologyLtd'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. 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 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".

Shanghai Huide Science & TechnologyLtd has an accrual ratio of -0.15 for the year to December 2023. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of CN¥193m in the last year, which was a lot more than its statutory profit of CN¥63.9m. Given that Shanghai Huide Science & TechnologyLtd had negative free cash flow in the prior corresponding period, the trailing twelve month resul of CN¥193m would seem to be a step in the right direction. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Shanghai Huide Science & TechnologyLtd.

The Impact Of Unusual Items On Profit

Shanghai Huide Science & TechnologyLtd's profit was reduced by unusual items worth CN¥11m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect Shanghai Huide Science & TechnologyLtd to produce a higher profit next year, all else being equal.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Shanghai Huide Science & TechnologyLtd profited from a tax benefit which contributed CN¥5.8m to profit. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. The receipt of a tax benefit is obviously a good thing, on its own. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth. While we think it's good that the company has booked a tax benefit, it does mean that there's every chance the statutory profit will come in a lot higher than it would be if the income was adjusted for one-off factors.

Our Take On Shanghai Huide Science & TechnologyLtd's Profit Performance

Summing up, Shanghai Huide Science & TechnologyLtd's accrual ratio and its unusual items suggest that its statutory earnings were temporarily depressed, while its tax benefit is having the opposite effect. Based on these factors, we think Shanghai Huide Science & TechnologyLtd's earnings potential is at least as good as it seems, and maybe even better! With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Be aware that Shanghai Huide Science & TechnologyLtd is showing 2 warning signs in our investment analysis and 1 of those is a bit concerning...

After our examination into the nature of Shanghai Huide Science & TechnologyLtd's profit, we've come away optimistic for the company. 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 that insiders are buying 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.