Investors were disappointed with Shandong Mining Machinery Group Co., Ltd.'s (SZSE:002526) earnings, despite the strong profit numbers. We did some digging and found some worrying underlying problems.

Examining Cashflow Against Shandong Mining Machinery Group's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Shandong Mining Machinery Group has an accrual ratio of 0.24 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¥430m, in contrast to the aforementioned profit of CN¥171.8m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥430m, this year, indicates high risk. 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 Shandong Mining Machinery Group.

The Impact Of Unusual Items On Profit

Unfortunately (in the short term) Shandong Mining Machinery Group saw its profit reduced by unusual items worth CN¥47m. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. If Shandong Mining Machinery Group doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On Shandong Mining Machinery Group's Profit Performance

In conclusion, Shandong Mining Machinery Group's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Given the contrasting considerations, we don't have a strong view as to whether Shandong Mining Machinery Group's profits are an apt reflection of its underlying potential for profit. So while earnings quality is important, it's equally important to consider the risks facing Shandong Mining Machinery Group at this point in time. At Simply Wall St, we found 2 warning signs for Shandong Mining Machinery Group and we think they deserve your attention.

Our examination of Shandong Mining Machinery Group has focussed on certain factors that can make its earnings look better than they are. But there is always more to discover if you are capable of focussing your mind on minutiae. 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.