Shareholders didn't seem to be thrilled with New East New Materials Co., Ltd's (SHSE:603110) recent earnings report, despite healthy profit numbers. Our analysis has found some concerning factors which weaken the profit's foundation.

Examining Cashflow Against New East New Materials' 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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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 December 2023, New East New Materials had an accrual ratio of 0.24. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Even though it reported a profit of CN¥52.0m, a look at free cash flow indicates it actually burnt through CN¥37m in the last year. It's worth noting that New East New Materials generated positive FCF of CN¥10m a year ago, so at least they've done it in the past. 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 New East New Materials.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥50m, 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. And, after all, that's exactly what the accounting terminology implies. New East New Materials had a rather significant contribution from unusual items relative to its profit to December 2023. 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 New East New Materials' Profit Performance

Summing up, New East New Materials received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue New East New Materials' profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into New East New Materials, you'd also look into what risks it is currently facing. For example - New East New Materials has 2 warning signs we think you should be aware of.

Our examination of New East New Materials 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. 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.