The subdued market reaction suggests that Shandong Keyuan Pharmaceutical Co., Ltd.'s (SZSE:301281) recent earnings didn't contain any surprises. However, we believe that investors should be aware of some underlying factors which may be of concern.

A Closer Look At Shandong Keyuan Pharmaceutical'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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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 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".

Shandong Keyuan Pharmaceutical has an accrual ratio of 0.22 for the year to December 2023. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Over the last year it actually had negative free cash flow of CN¥33m, in contrast to the aforementioned profit of CN¥77.0m. We saw that FCF was CN¥85m a year ago though, so Shandong Keyuan Pharmaceutical has at least been able to generate positive FCF in the past. 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 Shandong Keyuan Pharmaceutical.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Shandong Keyuan Pharmaceutical's profit was boosted by unusual items worth CN¥4.3m 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 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. Which is hardly surprising, given the name. If Shandong Keyuan Pharmaceutical 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 Shandong Keyuan Pharmaceutical's Profit Performance

Shandong Keyuan Pharmaceutical had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at Shandong Keyuan Pharmaceutical's statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into Shandong Keyuan Pharmaceutical, you'd also look into what risks it is currently facing. For instance, we've identified 3 warning signs for Shandong Keyuan Pharmaceutical (1 makes us a bit uncomfortable) you should be familiar with.

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. Some people consider a high return on equity to be a good sign of a quality business. 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.