Hongmian Zhihui Science and Technology Innovation Co.,Ltd.Guangzhou's (SZSE:000523) healthy profit numbers didn't contain any surprises for investors. We think this is due to investors looking beyond the statutory profits and being concerned with what they see.

A Closer Look At Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou'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. 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. The ratio shows us how much a company's profit exceeds its FCF.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to September 2024, Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou had an accrual ratio of 0.32. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥102m despite its profit of CN¥116.0m, mentioned above. It's worth noting that Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou generated positive FCF of CN¥221m a year ago, so at least they've done it in the past. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio. One positive for Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. 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 Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou.

How Do Unusual Items Influence Profit?

Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou's profit suffered from unusual items, which reduced profit by CN¥38m in the last twelve months. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. If Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou received a tax benefit of CN¥33m. 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. And since it previously lost money, it may well simply indicate the realisation of past tax losses. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal. So while we think it's great to receive a tax benefit, it does tend to imply an increased risk that the statutory profit overstates the sustainable earnings power of the business.

Our Take On Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou's Profit Performance

In conclusion, Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou's accrual ratio suggests that its statutory earnings are not backed by cash flow, in part due to the tax benefit it received; but the fact unusual items actually weighed on profit may create upside if those unusual items do not recur. Based on these factors, we think that Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou's statutory profits probably make it seem better than it is on an underlying level. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. You'd be interested to know, that we found 1 warning sign for Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou and you'll want to know about it.

Our examination of Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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.

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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.