There Are Some Holes In Hangzhou Alltest Biotech's (SHSE:688606) Solid Earnings Release

The healthy profit announcement from Hangzhou Alltest Biotech Co., Ltd. (SHSE:688606 ) didn't seem to impress investors. We think that they may be worried about something else, so we did some analysis and found that investors have noticed some soft numbers underlying the profit.

See our latest analysis for Hangzhou Alltest Biotech

A Closer Look At Hangzhou Alltest Biotech'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. 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. 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".

For the year to March 2024, Hangzhou Alltest Biotech had an accrual ratio of 0.47. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥245m despite its profit of CN¥184.8m, mentioned above. We also note that Hangzhou Alltest Biotech's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥245m. 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 Alltest Biotech.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Hangzhou Alltest Biotech's profit was boosted by unusual items worth CN¥44m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's as you'd expect, given these boosts are described as 'unusual'. Hangzhou Alltest Biotech had a rather significant contribution from unusual items relative to its profit to March 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 Alltest Biotech's Profit Performance

Hangzhou Alltest Biotech 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 Alltest Biotech'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 Alltest Biotech, you'd also look into what risks it is currently facing. In terms of investment risks, we've identified 3 warning signs with Hangzhou Alltest Biotech, and understanding these should be part of your investment process.

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. 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.