Investors appear disappointed with HONG RI DA Technology Company Limited's (SZSE:301285) recent earnings, despite the decent statutory profit number. Our analysis has found some underlying factors which may be cause for concern.

Examining Cashflow Against HONG RI DA Technology's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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.

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. 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, HONG RI DA Technology had an accrual ratio of 0.22. 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¥165m despite its profit of CN¥36.1m, 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¥165m, this year, indicates high risk. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of HONG RI DA Technology.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥16m, in the last year, probably goes some way to explain why its accrual ratio was so weak. 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. Which is hardly surprising, given the name. HONG RI DA Technology had a rather significant contribution from unusual items relative to its profit to September 2024. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that HONG RI DA Technology profited from a tax benefit which contributed CN¥7.1m to profit. This is meaningful because companies usually pay tax rather than receive tax benefits. We're sure the company was pleased with its tax benefit. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth. While we think it's good that the company has booked a tax benefit, it does mean that there's every chance the statutory profit will come in a lot higher than it would be if the income was adjusted for one-off factors.

Our Take On HONG RI DA Technology's Profit Performance

Summing up, HONG RI DA Technology's tax benefit and unusual items boosted its statutory profit leading to poor cash conversion, as reflected by its accrual ratio. For all the reasons mentioned above, we think that, at a glance, HONG RI DA Technology's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. If you want to do dive deeper into HONG RI DA Technology, you'd also look into what risks it is currently facing. Case in point: We've spotted 2 warning signs for HONG RI DA Technology you should be aware of.

Our examination of HONG RI DA Technology 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 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. 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.