There Are Some Reasons To Suggest That Hefei Kewell Power SystemLtd's (SHSE:688551) Earnings Are A Poor Reflection Of Profitability

Hefei Kewell Power System Co.,Ltd.'s (SHSE:688551) solid earnings report last week was underwhelming to investors. We think that they may be worried about something else, so we did some analysis and found that investors have noticed some soft numbers underlying the profit.

View our latest analysis for Hefei Kewell Power SystemLtd

A Closer Look At Hefei Kewell Power SystemLtd'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.

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

Hefei Kewell Power SystemLtd has an accrual ratio of 0.30 for the year to September 2024. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. Over the last year it actually had negative free cash flow of CN¥60m, in contrast to the aforementioned profit of CN¥93.4m. We also note that Hefei Kewell Power SystemLtd's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥60m. Having said that, there is more to the story. 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.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Hefei Kewell Power SystemLtd's profit was boosted by unusual items worth CN¥30m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. 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. Which is hardly surprising, given the name. We can see that Hefei Kewell Power SystemLtd's positive unusual items were quite significant relative to its profit in the year to September 2024. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Hefei Kewell Power SystemLtd's Profit Performance

Summing up, Hefei Kewell Power SystemLtd 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 Hefei Kewell Power SystemLtd's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Hefei Kewell Power SystemLtd as a business, it's important to be aware of any risks it's facing. For example, we've found that Hefei Kewell Power SystemLtd has 4 warning signs (1 is a bit concerning!) that deserve your attention before going any further with your analysis.

Our examination of Hefei Kewell Power SystemLtd 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 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 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.