Harbin Pharmaceutical Group's (SHSE:600664) Anemic Earnings Might Be Worse Than You Think

Investors weren't pleased with the recent soft earnings report from Harbin Pharmaceutical Group Co., Ltd. (SHSE:600664). Our analysis suggests that while the headline numbers were soft, there are some positive factors which shareholders may have missed.

View our latest analysis for Harbin Pharmaceutical Group

Examining Cashflow Against Harbin Pharmaceutical Group'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

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 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".

Harbin Pharmaceutical Group has an accrual ratio of -0.11 for the year to December 2023. That indicates that its free cash flow was a fair bit more than its statutory profit. Indeed, in the last twelve months it reported free cash flow of CN¥863m, well over the CN¥395.3m it reported in profit. Harbin Pharmaceutical Group shareholders are no doubt pleased that free cash flow improved over the last twelve months. 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 Harbin Pharmaceutical Group.

How Do Unusual Items Influence Profit?

Surprisingly, given Harbin Pharmaceutical Group's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥63m in unusual items. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. 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'. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Harbin Pharmaceutical Group's Profit Performance

Harbin Pharmaceutical Group's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Given the contrasting considerations, we don't have a strong view as to whether Harbin Pharmaceutical Group's profits are an apt reflection of its underlying potential for profit. Just as investors must consider earnings, it is also important to take into account the strength of a company's balance sheet. We've done some analysis and you can see our take on Harbin Pharmaceutical Group's balance sheet by clicking here.

Our examination of Harbin Pharmaceutical Group has focussed on certain factors that can make its earnings look better than they are. 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.