Shandong Swan CottonIndustrial Machinery Stock Co.,Ltd. (SHSE:603029) recently posted soft earnings but shareholders didn't react strongly. Our analysis suggests that they may be missing some concerning details underlying the profit numbers.

Examining Cashflow Against Shandong Swan CottonIndustrial Machinery StockLtd'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. The ratio shows us how much a company's profit exceeds its FCF.

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 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.

Shandong Swan CottonIndustrial Machinery StockLtd has an accrual ratio of 0.45 for the year to September 2024. 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. Even though it reported a profit of CN¥67.7m, a look at free cash flow indicates it actually burnt through CN¥195m in the last year. It's worth noting that Shandong Swan CottonIndustrial Machinery StockLtd generated positive FCF of CN¥140m a year ago, so at least they've done it in the past. 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. One positive for Shandong Swan CottonIndustrial Machinery StockLtd shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. As a result, some shareholders may be looking for stronger cash conversion in the current year.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Shandong Swan CottonIndustrial Machinery StockLtd.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥8.7m, 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. And, after all, that's exactly what the accounting terminology implies. If Shandong Swan CottonIndustrial Machinery StockLtd 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 Shandong Swan CottonIndustrial Machinery StockLtd's Profit Performance

Summing up, Shandong Swan CottonIndustrial Machinery StockLtd received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For the reasons mentioned above, we think that a perfunctory glance at Shandong Swan CottonIndustrial Machinery StockLtd's statutory profits might make it look better than it really is on an underlying level. If you'd like to know more about Shandong Swan CottonIndustrial Machinery StockLtd as a business, it's important to be aware of any risks it's facing. To help with this, we've discovered 2 warning signs (1 can't be ignored!) that you ought to be aware of before buying any shares in Shandong Swan CottonIndustrial Machinery StockLtd.

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. 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 with significant insider holdings 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.