Zhejiang Realsun Chemical Co.,Ltd. (SZSE:301212) 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.

Zooming In On Zhejiang Realsun ChemicalLtd's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to June 2024, Zhejiang Realsun ChemicalLtd recorded an accrual ratio of 0.37. 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¥28.8m, a look at free cash flow indicates it actually burnt through CN¥224m in the last year. We also note that Zhejiang Realsun ChemicalLtd's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥224m. 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zhejiang Realsun ChemicalLtd.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥2.8m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. Which is hardly surprising, given the name. If Zhejiang Realsun ChemicalLtd 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 Zhejiang Realsun ChemicalLtd's Profit Performance

Zhejiang Realsun ChemicalLtd had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue Zhejiang Realsun ChemicalLtd's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Zhejiang Realsun ChemicalLtd as a business, it's important to be aware of any risks it's facing. Every company has risks, and we've spotted 3 warning signs for Zhejiang Realsun ChemicalLtd (of which 1 can't be ignored!) you should know about.

Our examination of Zhejiang Realsun ChemicalLtd has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. But there are plenty of other ways to inform your opinion of a company. Some people consider a high return on equity to be a good sign of a quality business. 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.