Hangzhou First Applied Material's (SHSE:603806) Profits May Not Reveal Underlying Issues

Hangzhou First Applied Material Co., Ltd.'s (SHSE:603806) robust recent earnings didn't do much to move the stock. We believe that shareholders have noticed some concerning factors beyond the statutory profit numbers.

Check out our latest analysis for Hangzhou First Applied Material

Zooming In On Hangzhou First Applied Material'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. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Hangzhou First Applied Material has an accrual ratio of 0.21 for the year to December 2023. 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¥769m, in contrast to the aforementioned profit of CN¥1.85b. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥769m, this year, indicates high risk. 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.

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.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥249m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And, after all, that's exactly what the accounting terminology implies. 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 Hangzhou First Applied Material's Profit Performance

Summing up, Hangzhou First Applied Material received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Hangzhou First Applied Material's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Hangzhou First Applied Material as a business, it's important to be aware of any risks it's facing. For instance, we've identified 2 warning signs for Hangzhou First Applied Material (1 is concerning) you should be familiar with.

Our examination of Hangzhou First Applied Material has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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.