The market shrugged off Hengtong Logistics Co., Ltd.'s (SHSE:603223) solid earnings report. Our analysis showed that there are some concerning factors in the earnings that investors may be cautious of.

Examining Cashflow Against Hengtong Logistics' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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'.

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

Over the twelve months to December 2023, Hengtong Logistics recorded an accrual ratio of 0.21. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Even though it reported a profit of CN¥117.5m, a look at free cash flow indicates it actually burnt through CN¥320m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥320m, this year, indicates high risk. 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Hengtong Logistics.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Hengtong Logistics' profit was boosted by unusual items worth CN¥11m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And that's as you'd expect, given these boosts are described as 'unusual'. If Hengtong Logistics 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 Hengtong Logistics' Profit Performance

Hengtong Logistics had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at Hengtong Logistics' statutory profits might make it look better than it really is on an underlying level. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. At Simply Wall St, we found 1 warning sign for Hengtong Logistics and we think they deserve your attention.

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.