Shanghai Sanmao Enterprise (Group) Co., Ltd. (SHSE:600689) announced strong profits, but the stock was stagnant. Our analysis suggests that this might be because shareholders have noticed some concerning underlying factors.

A Closer Look At Shanghai Sanmao Enterprise (Group)'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. 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to December 2023, Shanghai Sanmao Enterprise (Group) recorded an accrual ratio of -0.24. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of CN¥53m during the period, dwarfing its reported profit of CN¥17.6m. Shanghai Sanmao Enterprise (Group)'s free cash flow improved over the last year, which is generally good to see. Having said that, there is more to the story. 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 Shanghai Sanmao Enterprise (Group).

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Shanghai Sanmao Enterprise (Group)'s profit was boosted by unusual items worth CN¥7.9m in the last twelve months. 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 that's as you'd expect, given these boosts are described as 'unusual'. We can see that Shanghai Sanmao Enterprise (Group)'s positive unusual items were quite significant relative to its profit in the year to December 2023. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Shanghai Sanmao Enterprise (Group)'s Profit Performance

In conclusion, Shanghai Sanmao Enterprise (Group)'s accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Given the contrasting considerations, we don't have a strong view as to whether Shanghai Sanmao Enterprise (Group)'s profits are an apt reflection of its underlying potential for profit. If you want to do dive deeper into Shanghai Sanmao Enterprise (Group), you'd also look into what risks it is currently facing. For instance, we've identified 3 warning signs for Shanghai Sanmao Enterprise (Group) (1 is a bit concerning) you should be familiar with.

Our examination of Shanghai Sanmao Enterprise (Group) has focussed on certain factors that can make its earnings look better than they are. 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 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.