Investors Shouldn't Be Too Comfortable With Huili Resources (Group)'s (HKG:1303) Robust Earnings

Huili Resources (Group) Limited (HKG:1303) announced strong profits, but the stock was stagnant. Our analysis suggests that shareholders have noticed something concerning in the numbers.

See our latest analysis for Huili Resources (Group)

A Closer Look At Huili Resources (Group)'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. 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".

Huili Resources (Group) has an accrual ratio of 0.34 for the year to December 2022. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. To wit, it produced free cash flow of CN¥122m during the period, falling well short of its reported profit of CN¥180.8m. At this point we should mention that Huili Resources (Group) did manage to increase its free cash flow in the last twelve months One positive for Huili Resources (Group) shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Huili Resources (Group).

Our Take On Huili Resources (Group)'s Profit Performance

As we have made quite clear, we're a bit worried that Huili Resources (Group) didn't back up the last year's profit with free cashflow. For this reason, we think that Huili Resources (Group)'s statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. On the bright side, the company showed enough improvement to book a profit this year, after losing money last year. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. To that end, you should learn about the 3 warning signs we've spotted with Huili Resources (Group) (including 2 which make us uncomfortable).

Today we've zoomed in on a single data point to better understand the nature of Huili Resources (Group)'s profit. 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.