The subdued stock price reaction suggests that Shanghai Kinlita Chemical Co., Ltd.'s (SZSE:300225) strong earnings didn't offer any surprises. We think that investors have missed some encouraging factors underlying the profit figures.

A Closer Look At Shanghai Kinlita Chemical'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. 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. The ratio shows us how much a company's profit exceeds its FCF.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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.

Over the twelve months to June 2024, Shanghai Kinlita Chemical recorded an accrual ratio of -0.11. That indicates that its free cash flow was a fair bit more than its statutory profit. In fact, it had free cash flow of CN¥105m in the last year, which was a lot more than its statutory profit of CN¥28.3m. Notably, Shanghai Kinlita Chemical had negative free cash flow last year, so the CN¥105m it produced this year was a welcome improvement.

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

Our Take On Shanghai Kinlita Chemical's Profit Performance

As we discussed above, Shanghai Kinlita Chemical has perfectly satisfactory free cash flow relative to profit. Because of this, we think Shanghai Kinlita Chemical's earnings potential is at least as good as it seems, and maybe even better! And it's also positive that the company showed enough improvement to book a profit this year, after losing money last year. 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 if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. In terms of investment risks, we've identified 1 warning sign with Shanghai Kinlita Chemical, and understanding it should be part of your investment process.

Today we've zoomed in on a single data point to better understand the nature of Shanghai Kinlita Chemical's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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 with high insider ownership.

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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.