A lackluster earnings announcement from Hengtong Logistics Co., Ltd. (SHSE:603223) last week didn't sink the stock price. However, we believe that investors should be aware of some underlying factors which may be of concern.

A Closer Look At Hengtong Logistics' 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. 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".

Over the twelve months to September 2024, Hengtong Logistics recorded an accrual ratio of 0.24. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Over the last year it actually had negative free cash flow of CN¥483m, in contrast to the aforementioned profit of CN¥117.9m. We also note that Hengtong Logistics' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥483m. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

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

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Hengtong Logistics' profit was boosted by unusual items worth CN¥11m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And that's as you'd expect, given these boosts are described as 'unusual'. If Hengtong Logistics doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Hengtong Logistics' Profit Performance

Summing up, Hengtong Logistics received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Hengtong Logistics' profits probably give an overly generous impression of its sustainable level of profitability. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. While conducting our analysis, we found that Hengtong Logistics has 1 warning sign and it would be unwise to ignore this.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. But there are plenty of other ways to inform your opinion of a company. 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. 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.

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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.