Investors were disappointed with Shanghai Material Trading Co., Ltd.'s (SHSE:600822) earnings, despite the strong profit numbers. We think that the market might be paying attention to some underlying factors that they find to be concerning.

A Closer Look At Shanghai Material Trading's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. 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, Shanghai Material Trading had an accrual ratio of -0.35. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of CN¥272m in the last year, which was a lot more than its statutory profit of CN¥140.0m. Notably, Shanghai Material Trading had negative free cash flow last year, so the CN¥272m it produced this year was a welcome improvement. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Shanghai Material Trading.

The Impact Of Unusual Items On Profit

Surprisingly, given Shanghai Material Trading's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥14m in unusual items. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And that's as you'd expect, given these boosts are described as 'unusual'. Shanghai Material Trading had a rather significant contribution from unusual items relative to its profit to December 2023. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Shanghai Material Trading's Profit Performance

Shanghai Material Trading's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Based on these factors, it's hard to tell if Shanghai Material Trading's profits are a reasonable reflection of its underlying profitability. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Every company has risks, and we've spotted 1 warning sign for Shanghai Material Trading you should know about.

Our examination of Shanghai Material Trading 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. 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.