Hangzhou Freely Communication Co., Ltd.'s (SHSE:603602) recent weak earnings report didn't cause a big stock movement. Our analysis suggests that along with soft profit numbers, investors should be aware of some other underlying weaknesses in the numbers.

Zooming In On Hangzhou Freely Communication'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'.

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, Hangzhou Freely Communication recorded an accrual ratio of 0.25. Unfortunately, that means its free cash flow fell significantly short of its reported profits. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥216m despite its profit of CN¥28.7m, mentioned above. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥216m, this year, indicates high risk.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Hangzhou Freely Communication.

Our Take On Hangzhou Freely Communication's Profit Performance

Hangzhou Freely Communication'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 Hangzhou Freely Communication's true underlying earnings power is actually less than its statutory profit. Sadly, its EPS was down over the last twelve months. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. When we did our research, we found 3 warning signs for Hangzhou Freely Communication (2 make us uncomfortable!) that we believe deserve your full attention.

Today we've zoomed in on a single data point to better understand the nature of Hangzhou Freely Communication'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.

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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.