Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou's (SZSE:000523) Earnings Seem To Be Promising

Hongmian Zhihui Science and Technology Innovation Co.,Ltd.Guangzhou's (SZSE:000523) recent earnings report didn't offer any surprises, with the shares unchanged over the last week. We did some digging, and we think that investors are missing some encouraging factors in the underlying numbers.

View our latest analysis for Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou

A Closer Look At Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou'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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. 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, Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou recorded an accrual ratio of -0.33. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of CN¥371m, well over the CN¥74.8m it reported in profit. Given that Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou had negative free cash flow in the prior corresponding period, the trailing twelve month resul of CN¥371m would seem to be a step in the right direction. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou.

How Do Unusual Items Influence Profit?

Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou's profit was reduced by unusual items worth CN¥46m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. 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. In the twelve months to December 2023, Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou had a big unusual items expense. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou profited from a tax benefit which contributed CN¥37m to profit. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! The receipt of a tax benefit is obviously a good thing, on its own. And given that it lost money last year, it seems possible that the benefit is evidence that it now expects to find value in its past tax losses. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth.

Our Take On Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou's Profit Performance

In conclusion, both Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative, but the presence of a tax benefits may be inflating the numbers in a way that won't persist. Based on these factors, we think Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou's earnings potential is at least as good as it seems, and maybe even better! So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. While conducting our analysis, we found that Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou has 1 warning sign and it would be unwise to ignore this.

Our examination of Hongmian Zhihui Science and Technology InnovationLtd.Guangzhou has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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.