Hengtong Logistics' (SHSE:603223) Profits Appear To Have Quality Issues

The market shrugged off Hengtong Logistics Co., Ltd.'s (SHSE:603223) solid earnings report. Our analysis showed that there are some concerning factors in the earnings that investors may be cautious of.

See our latest analysis for Hengtong Logistics

Zooming In On Hengtong Logistics' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. 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 December 2023, Hengtong Logistics recorded an accrual ratio of 0.21. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Over the last year it actually had negative free cash flow of CN¥320m, in contrast to the aforementioned profit of CN¥117.5m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥320m, this year, indicates high risk. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

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

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Hengtong Logistics' profit was boosted by unusual items worth CN¥11m in the last twelve months. 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 that's as you'd expect, given these boosts are described as 'unusual'. If Hengtong Logistics 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 Hengtong Logistics' Profit Performance

Hengtong Logistics had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue Hengtong Logistics' profits probably give an overly generous impression of its sustainable level of profitability. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For example, we've discovered 1 warning sign that you should run your eye over to get a better picture of Hengtong Logistics.

Our examination of Hengtong Logistics 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 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. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.