A lackluster earnings announcement from Jiangsu Ruitai New Energy Materials Co., Ltd. (SZSE:301238) last week didn't sink the stock price. However, we believe that investors should be aware of some underlying factors which may be of concern.

Examining Cashflow Against Jiangsu Ruitai New Energy 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. 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 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Jiangsu Ruitai New Energy Materials has an accrual ratio of 0.37 for the year to June 2024. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥762m despite its profit of CN¥294.0m, mentioned above. We saw that FCF was CN¥607m a year ago though, so Jiangsu Ruitai New Energy Materials has at least been able to generate positive FCF in the past. 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. The good news for shareholders is that Jiangsu Ruitai New Energy Materials' 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 Jiangsu Ruitai New Energy Materials.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Jiangsu Ruitai New Energy Materials' profit was boosted by unusual items worth CN¥25m 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 crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. Which is hardly surprising, given the name. If Jiangsu Ruitai New Energy Materials 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 Jiangsu Ruitai New Energy Materials' Profit Performance

Summing up, Jiangsu Ruitai New Energy Materials received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For the reasons mentioned above, we think that a perfunctory glance at Jiangsu Ruitai New Energy Materials' statutory profits might make it look better than it really is on an underlying level. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Case in point: We've spotted 2 warning signs for Jiangsu Ruitai New Energy Materials you should be mindful of and 1 of these is a bit concerning.

Our examination of Jiangsu Ruitai New Energy 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 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 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.