The market shrugged off Guangdong Modern High-tech Fiber Co., Ltd's (SZSE:300876) weak earnings report. Despite the market responding positively, we think that there are several concerning factors that investors should be aware of.

Zooming In On Guangdong Modern High-tech Fiber'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). 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. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to December 2023, Guangdong Modern High-tech Fiber recorded an accrual ratio of 0.38. 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. Even though it reported a profit of CN¥21.5m, a look at free cash flow indicates it actually burnt through CN¥316m in the last year. We also note that Guangdong Modern High-tech Fiber's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥316m. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥3.5m, 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. Which is hardly surprising, given the name. If Guangdong Modern High-tech Fiber 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 Guangdong Modern High-tech Fiber's Profit Performance

Guangdong Modern High-tech Fiber 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 Guangdong Modern High-tech Fiber's statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into Guangdong Modern High-tech Fiber, you'd also look into what risks it is currently facing. When we did our research, we found 4 warning signs for Guangdong Modern High-tech Fiber (1 is a bit unpleasant!) that we believe deserve your full attention.

Our examination of Guangdong Modern High-tech Fiber 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 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 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.