There Are Some Reasons To Suggest That Hangzhou Kelin Electric's (SHSE:688611) Earnings Are A Poor Reflection Of Profitability

Shareholders didn't seem to be thrilled with Hangzhou Kelin Electric Co., Ltd.'s (SHSE:688611) recent earnings report, despite healthy profit numbers. We think that they might be concerned about some underlying details that our analysis found.

See our latest analysis for Hangzhou Kelin Electric

A Closer Look At Hangzhou Kelin Electric'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). 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".

Hangzhou Kelin Electric has an accrual ratio of 0.54 for the year to September 2024. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥243m despite its profit of CN¥59.6m, mentioned above. We also note that Hangzhou Kelin Electric's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥243m. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

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

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥7.9m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And that's as you'd expect, given these boosts are described as 'unusual'. If Hangzhou Kelin Electric 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 Hangzhou Kelin Electric's Profit Performance

Hangzhou Kelin Electric had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at Hangzhou Kelin Electric's statutory profits might make it look better than it really is on an underlying level. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. For example, we've found that Hangzhou Kelin Electric has 3 warning signs (2 are a bit concerning!) that deserve your attention before going any further with your analysis.

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 is always more to discover if you are capable of focussing your mind on minutiae. 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. 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.