Hubei Hongyuan Pharmaceutical Technology's (SZSE:301246) Soft Earnings Are Actually Better Than They Appear

Hubei Hongyuan Pharmaceutical Technology Co., Ltd.'s (SZSE:301246) recent soft profit numbers didn't appear to worry shareholders, as the stock price showed strength. We think that investors might be looking at some positive factors beyond the earnings numbers.

View our latest analysis for Hubei Hongyuan Pharmaceutical Technology

Examining Cashflow Against Hubei Hongyuan Pharmaceutical Technology'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. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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 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".

For the year to March 2024, Hubei Hongyuan Pharmaceutical Technology had an accrual ratio of 0.24. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Over the last year it actually had negative free cash flow of CN¥548m, in contrast to the aforementioned profit of CN¥53.6m. We also note that Hubei Hongyuan Pharmaceutical Technology's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥548m. However, that's not all there is to consider. 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 Hubei Hongyuan Pharmaceutical Technology.

The Impact Of Unusual Items On Profit

Unfortunately (in the short term) Hubei Hongyuan Pharmaceutical Technology saw its profit reduced by unusual items worth CN¥14m. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect Hubei Hongyuan Pharmaceutical Technology to produce a higher profit next year, all else being equal.

Our Take On Hubei Hongyuan Pharmaceutical Technology's Profit Performance

In conclusion, Hubei Hongyuan Pharmaceutical Technology's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Based on these factors, it's hard to tell if Hubei Hongyuan Pharmaceutical Technology's profits are a reasonable reflection of its underlying profitability. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. For example, we've found that Hubei Hongyuan Pharmaceutical Technology has 2 warning signs (1 is a bit unpleasant!) that deserve your attention before going any further with your analysis.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.