Hangzhou Huasu TechnologyLtd's (SZSE:301157) Sluggish Earnings Might Be Just The Beginning Of Its Problems

The subdued market reaction suggests that Hangzhou Huasu Technology Co.,Ltd.'s (SZSE:301157) 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 Hangzhou Huasu TechnologyLtd

A Closer Look At Hangzhou Huasu TechnologyLtd's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Hangzhou Huasu TechnologyLtd has an accrual ratio of 0.31 for the year to June 2024. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥61m despite its profit of CN¥42.7m, mentioned above. We also note that Hangzhou Huasu TechnologyLtd's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥61m. 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 Hangzhou Huasu TechnologyLtd.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥2.5m, 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. 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, after all, that's exactly what the accounting terminology implies. If Hangzhou Huasu TechnologyLtd 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 Huasu TechnologyLtd's Profit Performance

Hangzhou Huasu TechnologyLtd 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 Huasu TechnologyLtd's statutory profits might make it look better than it really is on an underlying level. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. To that end, you should learn about the 2 warning signs we've spotted with Hangzhou Huasu TechnologyLtd (including 1 which is a bit concerning).

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 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.