Harson Trading (China) Co.,Ltd.'s (SHSE:603958) strong earnings report was rewarded with a positive stock price move. We did some digging and found some further encouraging factors that investors will like.

Zooming In On Harson Trading (China)Ltd'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. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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 March 2024, Harson Trading (China)Ltd recorded an accrual ratio of -0.15. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of CN¥85m, well over the CN¥11.8m it reported in profit. Notably, Harson Trading (China)Ltd had negative free cash flow last year, so the CN¥85m it produced this year was a welcome improvement. Having said that, there is more to the story. 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 Harson Trading (China)Ltd.

How Do Unusual Items Influence Profit?

Harson Trading (China)Ltd's profit was reduced by unusual items worth CN¥18m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. 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, after all, that's exactly what the accounting terminology implies. In the twelve months to March 2024, Harson Trading (China)Ltd had a big unusual items expense. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.

Our Take On Harson Trading (China)Ltd's Profit Performance

Considering both Harson Trading (China)Ltd's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Based on these factors, we think Harson Trading (China)Ltd's underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. While conducting our analysis, we found that Harson Trading (China)Ltd has 2 warning signs and it would be unwise to ignore these.

Our examination of Harson Trading (China)Ltd has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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 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.