Zhejiang Three Stars New Materials Co., Ltd.'s (SHSE:603578) recent weak earnings report didn't cause a big stock movement. However, we believe that investors should be aware of some underlying factors which may be of concern.

A Closer Look At Zhejiang Three Stars New Materials' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to June 2024, Zhejiang Three Stars New Materials had an accrual ratio of 1.19. 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. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥1.2b despite its profit of CN¥65.5m, mentioned above. It's worth noting that Zhejiang Three Stars New Materials generated positive FCF of CN¥29m a year ago, so at least they've done it in the past.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zhejiang Three Stars New Materials.

Our Take On Zhejiang Three Stars New Materials' Profit Performance

As we discussed above, we think Zhejiang Three Stars New Materials' earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that Zhejiang Three Stars New Materials' statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. In further bad news, its earnings per share decreased in the last year. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. If you want to do dive deeper into Zhejiang Three Stars New Materials, you'd also look into what risks it is currently facing. When we did our research, we found 4 warning signs for Zhejiang Three Stars New Materials (1 is significant!) that we believe deserve your full attention.

This note has only looked at a single factor that sheds light on the nature of Zhejiang Three Stars New Materials' profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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.