Hengsheng Energy's (SHSE:605580) Shareholders May Want To Dig Deeper Than Statutory Profit

Hengsheng Energy Co., Ltd's (SHSE:605580 ) stock didn't jump after it announced some healthy earnings. Our analysis showed that there are some concerning factors in the earnings that investors may be cautious of.

View our latest analysis for Hengsheng Energy

Zooming In On Hengsheng Energy'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. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to December 2023, Hengsheng Energy recorded an accrual ratio of 0.26. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Even though it reported a profit of CN¥135.8m, a look at free cash flow indicates it actually burnt through CN¥106m in the last year. We also note that Hengsheng Energy's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥106m. 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 Hengsheng Energy.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Hengsheng Energy's profit was boosted by unusual items worth CN¥21m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. If Hengsheng Energy 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 Hengsheng Energy's Profit Performance

Summing up, Hengsheng Energy 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 Hengsheng Energy's profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into Hengsheng Energy, you'd also look into what risks it is currently facing. For example, Hengsheng Energy has 3 warning signs (and 1 which is a bit concerning) we think you should know about.

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. 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.