We Think Hangzhou First Applied Material's (SHSE:603806) Healthy Earnings Might Be Conservative

The market seemed underwhelmed by last week's earnings announcement from Hangzhou First Applied Material Co., Ltd. (SHSE:603806) despite the healthy numbers. We did some analysis to find out why and believe that investors might be missing some encouraging factors contained in the earnings.

See our latest analysis for Hangzhou First Applied Material

Zooming In On Hangzhou First Applied Material's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to September 2024, Hangzhou First Applied Material had an accrual ratio of -0.15. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of CN¥4.1b during the period, dwarfing its reported profit of CN¥1.68b. Notably, Hangzhou First Applied Material had negative free cash flow last year, so the CN¥4.1b it produced this year was a welcome improvement. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

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.

How Do Unusual Items Influence Profit?

Surprisingly, given Hangzhou First Applied Material's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥174m in unusual items. 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 analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. If Hangzhou First Applied Material doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Hangzhou First Applied Material's Profit Performance

Hangzhou First Applied Material'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. Based on these factors, we think that Hangzhou First Applied Material's profits are a reasonably conservative guide to its underlying profitability. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. You'd be interested to know, that we found 1 warning sign for Hangzhou First Applied Material and you'll want to know about this.

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 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 with high insider ownership.

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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.