Hevol Services Group's (HKG:6093) Problems Go Beyond Weak Profit

The subdued market reaction suggests that Hevol Services Group Co. Limited's (HKG:6093) recent earnings didn't contain any surprises. We think that investors are worried about some weaknesses underlying the earnings.

See our latest analysis for Hevol Services Group

A Closer Look At Hevol Services Group's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. The ratio shows us how much a company's profit exceeds its FCF.

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".

Over the twelve months to June 2024, Hevol Services Group recorded an accrual ratio of 0.32. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Over the last year it actually had negative free cash flow of CN¥102m, in contrast to the aforementioned profit of CN¥63.2m. We saw that FCF was CN¥90m a year ago though, so Hevol Services Group has at least been able to generate positive FCF in the past. 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. The good news for shareholders is that Hevol Services Group's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Hevol Services Group.

The Impact Of Unusual Items On Profit

Unfortunately (in the short term) Hevol Services Group saw its profit reduced by unusual items worth CN¥12m. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. If Hevol Services Group doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On Hevol Services Group's Profit Performance

In conclusion, Hevol Services Group's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Having considered these factors, we don't think Hevol Services Group's statutory profits give an overly harsh view of the business. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. In terms of investment risks, we've identified 1 warning sign with Hevol Services Group, and understanding this should be part of your investment process.

Our examination of Hevol Services Group has focussed on certain factors that can make its earnings look better than they are. But there are plenty of other ways to inform your opinion of a company. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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.