Shanghai Karon Eco-Valve Manufacturing Co., Ltd. (SZSE:301151) 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.

A Closer Look At Shanghai Karon Eco-Valve Manufacturing'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. 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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Shanghai Karon Eco-Valve Manufacturing has an accrual ratio of 0.67 for the year to June 2024. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Over the last year it actually had negative free cash flow of CN¥542m, in contrast to the aforementioned profit of CN¥79.8m. We also note that Shanghai Karon Eco-Valve Manufacturing's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥542m. 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 Shanghai Karon Eco-Valve Manufacturing.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Shanghai Karon Eco-Valve Manufacturing's profit was boosted by unusual items worth CN¥8.7m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. 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. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Shanghai Karon Eco-Valve Manufacturing's Profit Performance

Summing up, Shanghai Karon Eco-Valve Manufacturing received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For the reasons mentioned above, we think that a perfunctory glance at Shanghai Karon Eco-Valve Manufacturing's statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into Shanghai Karon Eco-Valve Manufacturing, you'd also look into what risks it is currently facing. Case in point: We've spotted 4 warning signs for Shanghai Karon Eco-Valve Manufacturing you should be mindful of and 3 of these bad boys shouldn't be ignored.

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 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 with high insider ownership.

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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.