Investors were disappointed with Xiangyang Changyuandonggu Industry Co., Ltd.'s (SHSE:603950) earnings, despite the strong profit numbers. Our analysis uncovered some concerning factors that we believe the market might be paying attention to.

Zooming In On Xiangyang Changyuandonggu Industry's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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.

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. 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 December 2023, Xiangyang Changyuandonggu Industry had an accrual ratio of 0.25. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Even though it reported a profit of CN¥218.6m, a look at free cash flow indicates it actually burnt through CN¥400m in the last year. It's worth noting that Xiangyang Changyuandonggu Industry generated positive FCF of CN¥32m a year ago, so at least they've done it in the past. However, that's not all there is to consider. 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 Xiangyang Changyuandonggu Industry.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥25m, 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. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And, after all, that's exactly what the accounting terminology implies. If Xiangyang Changyuandonggu Industry 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 Xiangyang Changyuandonggu Industry's Profit Performance

Xiangyang Changyuandonggu Industry had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at Xiangyang Changyuandonggu Industry's statutory profits might make it look better than it really is on an underlying level. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Every company has risks, and we've spotted 3 warning signs for Xiangyang Changyuandonggu Industry (of which 2 are a bit unpleasant!) you should know about.

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 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 that insiders are buying.

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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.