A lackluster earnings announcement from Shandong Sinoglory Health Food Co., Ltd (SHSE:603182) last week didn't sink the stock price. We think that investors are worried about some weaknesses underlying the earnings.

A Closer Look At Shandong Sinoglory Health Food'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. 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. 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".

For the year to December 2023, Shandong Sinoglory Health Food had an accrual ratio of 0.35. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Even though it reported a profit of CN¥110.1m, a look at free cash flow indicates it actually burnt through CN¥117m in the last year. We saw that FCF was CN¥64m a year ago though, so Shandong Sinoglory Health Food has at least been able to generate positive FCF in the past.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Shandong Sinoglory Health Food.

Our Take On Shandong Sinoglory Health Food's Profit Performance

As we have made quite clear, we're a bit worried that Shandong Sinoglory Health Food didn't back up the last year's profit with free cashflow. For this reason, we think that Shandong Sinoglory Health Food's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But at least holders can take some solace from the 12% per annum growth in EPS for the last three. 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. So while earnings quality is important, it's equally important to consider the risks facing Shandong Sinoglory Health Food at this point in time. Our analysis shows 2 warning signs for Shandong Sinoglory Health Food (1 is a bit unpleasant!) and we strongly recommend you look at them before investing.

This note has only looked at a single factor that sheds light on the nature of Shandong Sinoglory Health Food's profit. 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.