The subdued market reaction suggests that Huarong Chemical Co., Ltd.'s (SZSE:301256) recent earnings didn't contain any surprises. However, we believe that investors should be aware of some underlying factors which may be of concern.

Examining Cashflow Against Huarong Chemical'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to September 2024, Huarong Chemical had an accrual ratio of 0.35. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. Over the last year it actually had negative free cash flow of CN¥63m, in contrast to the aforementioned profit of CN¥98.4m. We also note that Huarong Chemical's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥63m.

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

Our Take On Huarong Chemical's Profit Performance

As we discussed above, we think Huarong Chemical's earnings were not supported by free cash flow, which might concern some investors. As a result, we think it may well be the case that Huarong Chemical's underlying earnings power is lower than its statutory profit. Sadly, its EPS was down over the last twelve months. 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. For instance, we've identified 3 warning signs for Huarong Chemical (2 make us uncomfortable) you should be familiar with.

This note has only looked at a single factor that sheds light on the nature of Huarong Chemical'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. 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.

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.