The recent earnings posted by Huadian Liaoning Energy Development Co.,Ltd (SHSE:600396) were solid, but the stock didn't move as much as we expected. However the statutory profit number doesn't tell the whole story, and we have found some factors which might be of concern to shareholders.

Zooming In On Huadian Liaoning Energy DevelopmentLtd'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. 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'.

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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to June 2024, Huadian Liaoning Energy DevelopmentLtd recorded an accrual ratio of 0.21. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. To wit, it produced free cash flow of CN¥160m during the period, falling well short of its reported profit of CN¥2.77b. Notably, Huadian Liaoning Energy DevelopmentLtd had negative free cash flow last year, so the CN¥160m it produced this year was a welcome improvement. The good news for shareholders is that Huadian Liaoning Energy DevelopmentLtd's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. 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 Huadian Liaoning Energy DevelopmentLtd.

Our Take On Huadian Liaoning Energy DevelopmentLtd's Profit Performance

Huadian Liaoning Energy DevelopmentLtd's accrual ratio for the last twelve months signifies cash conversion is less than ideal, which is a negative when it comes to our view of its earnings. Therefore, it seems possible to us that Huadian Liaoning Energy DevelopmentLtd's true underlying earnings power is actually less than its statutory profit. The good news is that it earned a profit in the last twelve months, despite its previous loss. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Case in point: We've spotted 2 warning signs for Huadian Liaoning Energy DevelopmentLtd you should be aware of.

This note has only looked at a single factor that sheds light on the nature of Huadian Liaoning Energy DevelopmentLtd's profit. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.