Hangzhou Honghua Digital Technology Stock's (SHSE:688789) Solid Earnings May Rest On Weak Foundations

The market for Hangzhou Honghua Digital Technology Stock Company LTD.'s (SHSE:688789) stock was strong after it released a healthy earnings report last week. However, we think that shareholders should be cautious as we found some worrying factors underlying the profit.

Check out our latest analysis for Hangzhou Honghua Digital Technology Stock

Examining Cashflow Against Hangzhou Honghua Digital Technology Stock'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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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.

Over the twelve months to March 2024, Hangzhou Honghua Digital Technology Stock recorded an accrual ratio of 0.35. 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. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥224m despite its profit of CN¥347.7m, mentioned above. We saw that FCF was CN¥23m a year ago though, so Hangzhou Honghua Digital Technology Stock has at least been able to generate positive FCF in the past.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

Our Take On Hangzhou Honghua Digital Technology Stock's Profit Performance

As we have made quite clear, we're a bit worried that Hangzhou Honghua Digital Technology Stock didn't back up the last year's profit with free cashflow. For this reason, we think that Hangzhou Honghua Digital Technology Stock's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. Nonetheless, it's still worth noting that its earnings per share have grown at 26% over the last three years. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. In terms of investment risks, we've identified 1 warning sign with Hangzhou Honghua Digital Technology Stock, and understanding it should be part of your investment process.

Today we've zoomed in on a single data point to better understand the nature of Hangzhou Honghua Digital Technology Stock'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. 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 that insiders are buying 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.