Unsurprisingly, Hangzhou Freely Communication Co., Ltd.'s (SHSE:603602) stock price was strong on the back of its healthy earnings report. However, we think that shareholders may be missing some concerning details in the numbers.

Examining Cashflow Against Hangzhou Freely Communication'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). 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.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to March 2024, Hangzhou Freely Communication had 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¥40.0m, a look at free cash flow indicates it actually burnt through CN¥140m in the last year. We also note that Hangzhou Freely Communication's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥140m.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Hangzhou Freely Communication.

Our Take On Hangzhou Freely Communication's Profit Performance

Hangzhou Freely Communication didn't convert much of its profit to free cash flow in the last year, which some investors may consider rather suboptimal. Therefore, it seems possible to us that Hangzhou Freely Communication's true underlying earnings power is actually less than its statutory profit. But on the bright side, its earnings per share have grown at an extremely impressive rate over the last three years. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So while earnings quality is important, it's equally important to consider the risks facing Hangzhou Freely Communication at this point in time. You'd be interested to know, that we found 3 warning signs for Hangzhou Freely Communication and you'll want to know about these.

This note has only looked at a single factor that sheds light on the nature of Hangzhou Freely Communication's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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.