Hualan Group's (SZSE:301027) Sluggish Earnings Might Be Just The Beginning Of Its Problems

The subdued market reaction suggests that Hualan Group Co., Ltd.'s (SZSE:301027) recent earnings didn't contain any surprises. Our analysis suggests that along with soft profit numbers, investors should be aware of some other underlying weaknesses in the numbers.

Check out our latest analysis for Hualan Group

Examining Cashflow Against Hualan Group'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. 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'.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. While having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. 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 March 2024, Hualan Group recorded an accrual ratio of 0.41. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of CN¥7.38m, a look at free cash flow indicates it actually burnt through CN¥190m in the last year. We also note that Hualan Group's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥190m.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Hualan Group.

Our Take On Hualan Group's Profit Performance

As we have made quite clear, we're a bit worried that Hualan Group didn't back up the last year's profit with free cashflow. For this reason, we think that Hualan Group's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. In further bad news, its earnings per share decreased in the last year. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For example, we've found that Hualan Group has 4 warning signs (3 are significant!) that deserve your attention before going any further with your analysis.

This note has only looked at a single factor that sheds light on the nature of Hualan Group's profit. 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 that insiders are buying.

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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.