The recent earnings posted by Shang Hai Ya Tong Co.,Ltd. (SHSE:600692) were solid, but the stock didn't move as much as we expected. However the statutory profit number doesn't tell the whole story, and we have found some factors which might be of concern to shareholders.

A Closer Look At Shang Hai Ya TongLtd'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.

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. 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, Shang Hai Ya TongLtd had an accrual ratio of -0.52. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. In fact, it had free cash flow of CN¥832m in the last year, which was a lot more than its statutory profit of CN¥37.2m. Given that Shang Hai Ya TongLtd had negative free cash flow in the prior corresponding period, the trailing twelve month resul of CN¥832m would seem to be a step in the right direction. Having said that, there is more to the story. 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 Shang Hai Ya TongLtd.

The Impact Of Unusual Items On Profit

Surprisingly, given Shang Hai Ya TongLtd's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥12m in unusual items. 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 that's as you'd expect, given these boosts are described as 'unusual'. We can see that Shang Hai Ya TongLtd's positive unusual items were quite significant relative to its profit in the year to June 2024. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Shang Hai Ya TongLtd's Profit Performance

In conclusion, Shang Hai Ya TongLtd's accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Given the contrasting considerations, we don't have a strong view as to whether Shang Hai Ya TongLtd's profits are an apt reflection of its underlying potential for profit. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Be aware that Shang Hai Ya TongLtd is showing 3 warning signs in our investment analysis and 2 of those are significant...

Our examination of Shang Hai Ya TongLtd has focussed on certain factors that can make its earnings look better than they are. 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. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks with significant insider holdings to be useful.

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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.