Shahe Industrial Co., Ltd. (SZSE:000014) just released a solid earnings report, and the stock displayed some strength. Despite this, our analysis suggests that there are some factors weakening the foundations of those good profit numbers.

Zooming In On Shahe Industrial'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. The ratio shows us how much a company's profit exceeds its FCF.

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. 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 March 2024, Shahe Industrial recorded an accrual ratio of 0.43. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. Indeed, in the last twelve months it reported free cash flow of CN¥31m, which is significantly less than its profit of CN¥406.6m. Shahe Industrial shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months. One positive for Shahe Industrial 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. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Shahe Industrial.

Our Take On Shahe Industrial's Profit Performance

As we have made quite clear, we're a bit worried that Shahe Industrial didn't back up the last year's profit with free cashflow. As a result, we think it may well be the case that Shahe Industrial's underlying earnings power is lower than its statutory profit. And we are pleased to note that EPS is at least heading in the right direction in the alst twelve months. 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. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. For example, Shahe Industrial has 2 warning signs (and 1 which is potentially serious) we think you should know about.

This note has only looked at a single factor that sheds light on the nature of Shahe Industrial's profit. 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.