Why Huarong Chemical's (SZSE:301256) Shaky Earnings Are Just The Beginning Of Its Problems

Investors were disappointed by Huarong Chemical Co., Ltd.'s (SZSE:301256 ) latest earnings release. Our analysis has found some reasons to be concerned, beyond the weak headline numbers.

View our latest analysis for Huarong Chemical

Zooming In On Huarong Chemical's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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.

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".

Huarong Chemical has an accrual ratio of 0.46 for the year to March 2024. As a general rule, that bodes poorly for future profitability. 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¥63m despite its profit of CN¥123.2m, mentioned above. It's worth noting that Huarong Chemical generated positive FCF of CN¥125m a year ago, so at least they've done it in the past.

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

Our Take On Huarong Chemical's Profit Performance

As we have made quite clear, we're a bit worried that Huarong Chemical didn't back up the last year's profit with free cashflow. For this reason, we think that Huarong Chemical's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. Sadly, its EPS was down over the last twelve months. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Every company has risks, and we've spotted 2 warning signs for Huarong Chemical (of which 1 is a bit unpleasant!) you should know about.

This note has only looked at a single factor that sheds light on the nature of Huarong Chemical's profit. 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. 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.