Some May Be Optimistic About Hwaxin EnvironmentalLtd's (SZSE:301265) Earnings

Soft earnings didn't appear to concern Hwaxin Environmental Co.,Ltd.'s (SZSE:301265) shareholders over the last week. We think that the softer headline numbers might be getting counterbalanced by some positive underlying factors.

View our latest analysis for Hwaxin EnvironmentalLtd

Examining Cashflow Against Hwaxin EnvironmentalLtd's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. The ratio shows us how much a company's profit exceeds its FCF.

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. 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 March 2024, Hwaxin EnvironmentalLtd had an accrual ratio of 0.20. Unfortunately, that means its free cash flow fell significantly short of its reported profits. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥148m despite its profit of CN¥60.5m, mentioned above. We saw that FCF was CN¥23m a year ago though, so Hwaxin EnvironmentalLtd has at least been able to generate positive FCF in the past. However, that's not all there is to consider. 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 Hwaxin EnvironmentalLtd.

The Impact Of Unusual Items On Profit

Hwaxin EnvironmentalLtd's profit suffered from unusual items, which reduced profit by CN¥11m in the last twelve months. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. Assuming those unusual expenses don't come up again, we'd therefore expect Hwaxin EnvironmentalLtd to produce a higher profit next year, all else being equal.

Our Take On Hwaxin EnvironmentalLtd's Profit Performance

Hwaxin EnvironmentalLtd saw unusual items weigh on its profit, which should have made it easier to show high cash conversion, which it did not do, according to its accrual ratio. Given the contrasting considerations, we don't have a strong view as to whether Hwaxin EnvironmentalLtd's profits are an apt reflection of its underlying potential for profit. So while earnings quality is important, it's equally important to consider the risks facing Hwaxin EnvironmentalLtd at this point in time. Case in point: We've spotted 5 warning signs for Hwaxin EnvironmentalLtd you should be mindful of and 2 of these are significant.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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. 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.