Hunan Copote Science TechnologyLtd's (SHSE:600476) Profits May Be Overstating Its True Earnings Potential

Hunan Copote Science Technology Co.,Ltd. (SHSE:600476) posted some decent earnings, but shareholders didn't react strongly. Our analysis suggests they may be concerned about some underlying details.

Check out our latest analysis for Hunan Copote Science TechnologyLtd

A Closer Look At Hunan Copote Science TechnologyLtd'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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to March 2024, Hunan Copote Science TechnologyLtd had an accrual ratio of 0.53. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥206m despite its profit of CN¥9.73m, mentioned above. We also note that Hunan Copote Science TechnologyLtd's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥206m. However, as we will discuss below, we can see that the company's accrual ratio has been impacted by its tax situation. This would partially explain why the accrual ratio was so poor.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Hunan Copote Science TechnologyLtd.

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that Hunan Copote Science TechnologyLtd received a tax benefit of CN¥2.5m. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. We're sure the company was pleased with its tax benefit. And given that it lost money last year, it seems possible that the benefit is evidence that it now expects to find value in its past tax losses. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth. While we think it's good that the company has booked a tax benefit, it does mean that there's every chance the statutory profit will come in a lot higher than it would be if the income was adjusted for one-off factors.

Our Take On Hunan Copote Science TechnologyLtd's Profit Performance

Hunan Copote Science TechnologyLtd's accrual ratio indicates weak cashflow relative to earnings, which perhaps arises in part from the tax benefit it received this year. If the tax benefit is not repeated, then profit would drop next year, all else being equal. Considering all this we'd argue Hunan Copote Science TechnologyLtd's profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Hunan Copote Science TechnologyLtd at this point in time. For example, we've discovered 2 warning signs that you should run your eye over to get a better picture of Hunan Copote Science TechnologyLtd.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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. 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.