Despite announcing strong earnings, Shenzhen RongDa Photosensitive Science & Technology Co., Ltd.'s (SZSE:300576) stock was sluggish. We did some digging and found some worrying underlying problems.

Zooming In On Shenzhen RongDa Photosensitive Science & Technology's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. 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 December 2023, Shenzhen RongDa Photosensitive Science & Technology had an accrual ratio of 0.38. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥185m despite its profit of CN¥85.5m, mentioned above. It's worth noting that Shenzhen RongDa Photosensitive Science & Technology generated positive FCF of CN¥60m a year ago, so at least they've done it in the past. 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. One positive for Shenzhen RongDa Photosensitive Science & Technology 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 Shenzhen RongDa Photosensitive Science & Technology.

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) Shenzhen RongDa Photosensitive Science & Technology saw its profit reduced by unusual items worth CN¥21m. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. 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. If Shenzhen RongDa Photosensitive Science & Technology 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 Shenzhen RongDa Photosensitive Science & Technology's Profit Performance

Shenzhen RongDa Photosensitive Science & Technology saw unusual items weigh on its profit, which should have made it easier to show high cash conversion, which it did not do, according to its accrual ratio. Having considered these factors, we don't think Shenzhen RongDa Photosensitive Science & Technology's statutory profits give an overly harsh view of the business. If you want to do dive deeper into Shenzhen RongDa Photosensitive Science & Technology, you'd also look into what risks it is currently facing. Every company has risks, and we've spotted 2 warning signs for Shenzhen RongDa Photosensitive Science & Technology (of which 1 is significant!) you should know about.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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.