The recent earnings posted by Renxin New Material Co.,Ltd. (SZSE:301395) were solid, but the stock didn't move as much as we expected. We think this is due to investors looking beyond the statutory profits and being concerned with what they see.

Zooming In On Renxin New MaterialLtd'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). 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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 it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to September 2024, Renxin New MaterialLtd had an accrual ratio of 0.37. 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. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥134m despite its profit of CN¥62.4m, mentioned above. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥134m, this year, indicates high risk. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Renxin New MaterialLtd.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Renxin New MaterialLtd's profit was boosted by unusual items worth CN¥5.2m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's as you'd expect, given these boosts are described as 'unusual'. If Renxin New MaterialLtd doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Renxin New MaterialLtd's Profit Performance

Renxin New MaterialLtd had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue Renxin New MaterialLtd's profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into Renxin New MaterialLtd, you'd also look into what risks it is currently facing. While conducting our analysis, we found that Renxin New MaterialLtd has 3 warning signs and it would be unwise to ignore them.

Our examination of Renxin New MaterialLtd has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. But there is always more to discover if you are capable of focussing your mind on minutiae. 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 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.