Hangzhou Wensli Silk Culture (SZSE:301066) Is Posting Healthy Earnings, But It Is Not All Good News

Investors were disappointed with Hangzhou Wensli Silk Culture Co., Ltd.'s (SZSE:301066) recent earnings release. Our analysis found several concerning factors in the earnings report beyond the strong statutory profit number.

View our latest analysis for Hangzhou Wensli Silk Culture

Examining Cashflow Against Hangzhou Wensli Silk Culture'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. The ratio shows us how much a company's profit exceeds its FCF.

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 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 Wensli Silk Culture has an accrual ratio of 0.38 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¥131m despite its profit of CN¥38.3m, mentioned above. It's worth noting that Hangzhou Wensli Silk Culture generated positive FCF of CN¥34m a year ago, so at least they've done it in the past. 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. The good news for shareholders is that Hangzhou Wensli Silk Culture's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

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

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥11m, 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. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And that's as you'd expect, given these boosts are described as 'unusual'. We can see that Hangzhou Wensli Silk Culture's positive unusual items were quite significant relative to its profit in the year to September 2024. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Hangzhou Wensli Silk Culture's Profit Performance

Hangzhou Wensli Silk Culture 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 Wensli Silk Culture's statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into Hangzhou Wensli Silk Culture, you'd also look into what risks it is currently facing. For example, Hangzhou Wensli Silk Culture has 4 warning signs (and 2 which are a bit concerning) we think you should know about.

Our examination of Hangzhou Wensli Silk Culture has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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 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.