After announcing weak earnings, Shanghai Tongji Science&Technology Industrial Co.,Ltd's (SHSE:600846) stock was strong. Despite the strength in the stock, we feel that investors should be cautious about some numbers in the earnings.

Zooming In On Shanghai Tongji Science&Technology IndustrialLtd'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. 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'.

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 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to March 2024, Shanghai Tongji Science&Technology IndustrialLtd had an accrual ratio of 1.27. 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. Over the last year it actually had negative free cash flow of CN¥2.4b, in contrast to the aforementioned profit of CN¥373.9m. It's worth noting that Shanghai Tongji Science&Technology IndustrialLtd generated positive FCF of CN¥139m a year ago, so at least they've done it in the past. Having said that, there is more to the story. 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 Tongji Science&Technology IndustrialLtd.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥49m, in the last year, probably goes some way to explain why its accrual ratio was so weak. 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. Which is hardly surprising, given the name. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Shanghai Tongji Science&Technology IndustrialLtd's Profit Performance

Shanghai Tongji Science&Technology IndustrialLtd had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue Shanghai Tongji Science&Technology IndustrialLtd's profits probably give an overly generous impression of its sustainable level of profitability. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. To help with this, we've discovered 3 warning signs (2 make us uncomfortable!) that you ought to be aware of before buying any shares in Shanghai Tongji Science&Technology IndustrialLtd.

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. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.