Impressive Earnings May Not Tell The Whole Story For Hengbo HoldingsLtd (SZSE:301225)

Hengbo Holdings Co.,Ltd. (SZSE:301225) just reported some strong earnings, and the market reacted accordingly with a healthy uplift in the share price. However, our analysis suggests that shareholders may be missing some factors that indicate the earnings result was not as good as it looked.

View our latest analysis for Hengbo HoldingsLtd

Zooming In On Hengbo HoldingsLtd's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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.

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 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, Hengbo HoldingsLtd had an accrual ratio of 0.34. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. Over the last year it actually had negative free cash flow of CN¥90m, in contrast to the aforementioned profit of CN¥122.5m. It's worth noting that Hengbo HoldingsLtd generated positive FCF of CN¥27m a year ago, so at least they've done it in the past. 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 Hengbo HoldingsLtd.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Hengbo HoldingsLtd's profit was boosted by unusual items worth CN¥15m 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 analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's as you'd expect, given these boosts are described as 'unusual'. If Hengbo HoldingsLtd 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 Hengbo HoldingsLtd's Profit Performance

Summing up, Hengbo HoldingsLtd received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For the reasons mentioned above, we think that a perfunctory glance at Hengbo HoldingsLtd's statutory profits might make it look better than it really is on an underlying level. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Our analysis shows 2 warning signs for Hengbo HoldingsLtd (1 doesn't sit too well with us!) and we strongly recommend you look at these before investing.

Our examination of Hengbo HoldingsLtd 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. 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.