The market wasn't impressed with the soft earnings from Weima Agricultural Machinery Co.,Ltd. (SZSE:301533) recently. We did some further digging and think they have a few more reasons to be concerned beyond the statutory profit.

A Closer Look At Weima Agricultural MachineryLtd'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. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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".

For the year to June 2024, Weima Agricultural MachineryLtd had an accrual ratio of 0.35. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. To wit, it produced free cash flow of CN¥658k during the period, falling well short of its reported profit of CN¥74.0m. Weima Agricultural MachineryLtd shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months. 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. The good news for shareholders is that Weima Agricultural MachineryLtd's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Weima Agricultural MachineryLtd.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Weima Agricultural MachineryLtd's profit was boosted by unusual items worth CN¥7.9m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. 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. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Weima Agricultural MachineryLtd's Profit Performance

Summing up, Weima Agricultural MachineryLtd 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 Weima Agricultural MachineryLtd's profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into Weima Agricultural MachineryLtd, you'd also look into what risks it is currently facing. For example, Weima Agricultural MachineryLtd has 2 warning signs (and 1 which is potentially serious) we think you should know about.

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 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 with high insider ownership.

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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.