Shanghai Material Trading Co., Ltd. (SHSE:600822) 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 Shanghai Material Trading'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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 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 September 2024, Shanghai Material Trading recorded an accrual ratio of 0.70. 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. Over the last year it actually had negative free cash flow of CN¥138m, in contrast to the aforementioned profit of CN¥57.0m. We also note that Shanghai Material Trading's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥138m. 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 Material Trading.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Shanghai Material Trading's profit was boosted by unusual items worth CN¥18m in the last twelve months. 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. And that's as you'd expect, given these boosts are described as 'unusual'. We can see that Shanghai Material Trading's positive unusual items were quite significant relative to its profit in the year to September 2024. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Shanghai Material Trading's Profit Performance

Shanghai Material Trading had a weak accrual ratio, but its profit did receive a boost from unusual items. On reflection, the above-mentioned factors give us the strong impression that Shanghai Material Trading'sunderlying earnings power is not as good as it might seem, based on the statutory profit numbers. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. When we did our research, we found 2 warning signs for Shanghai Material Trading (1 is a bit concerning!) that we believe deserve your full attention.

Our examination of Shanghai Material Trading 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 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.