Why Shandong Hualu-Hengsheng Chemical's (SHSE:600426) Shaky Earnings Are Just The Beginning Of Its Problems

The subdued market reaction suggests that Shandong Hualu-Hengsheng Chemical Co., Ltd.'s (SHSE:600426) recent earnings didn't contain any surprises. We think that investors are worried about some weaknesses underlying the earnings.

Check out our latest analysis for Shandong Hualu-Hengsheng Chemical

Examining Cashflow Against Shandong Hualu-Hengsheng Chemical's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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'.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Shandong Hualu-Hengsheng Chemical has an accrual ratio of 0.21 for the year to March 2024. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Over the last year it actually had negative free cash flow of CN¥3.4b, in contrast to the aforementioned profit of CN¥3.86b. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥3.4b, this year, indicates high risk.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

Our Take On Shandong Hualu-Hengsheng Chemical's Profit Performance

Shandong Hualu-Hengsheng Chemical didn't convert much of its profit to free cash flow in the last year, which some investors may consider rather suboptimal. Therefore, it seems possible to us that Shandong Hualu-Hengsheng Chemical's true underlying earnings power is actually less than its statutory profit. But at least holders can take some solace from the 31% per annum growth in EPS for the last three. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. To help with this, we've discovered 2 warning signs (1 is significant!) that you ought to be aware of before buying any shares in Shandong Hualu-Hengsheng Chemical.

Today we've zoomed in on a single data point to better understand the nature of Shandong Hualu-Hengsheng Chemical's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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.

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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.