The subdued market reaction suggests that Shandong Weifang Rainbow Chemical Co., Ltd's (SZSE:301035) recent earnings didn't contain any surprises. However, we believe that investors should be aware of some underlying factors which may be of concern.

A Closer Look At Shandong Weifang Rainbow Chemical's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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. 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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Shandong Weifang Rainbow Chemical has an accrual ratio of 0.42 for the year to June 2024. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of CN¥528.5m, a look at free cash flow indicates it actually burnt through CN¥1.8b in the last year. We also note that Shandong Weifang Rainbow Chemical's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥1.8b.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

Our Take On Shandong Weifang Rainbow Chemical's Profit Performance

As we have made quite clear, we're a bit worried that Shandong Weifang Rainbow Chemical didn't back up the last year's profit with free cashflow. For this reason, we think that Shandong Weifang Rainbow Chemical's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. In further bad news, its earnings per share decreased in the 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. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For instance, we've identified 3 warning signs for Shandong Weifang Rainbow Chemical (1 is a bit concerning) you should be familiar with.

This note has only looked at a single factor that sheds light on the nature of Shandong Weifang Rainbow Chemical's profit. 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 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.