The market shrugged off SF Diamond Co.,Ltd's (SZSE:300179) weak earnings report. Despite the market responding positively, we think that there are several concerning factors that investors should be aware of.

A Closer Look At SF DiamondLtd's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. 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. 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 September 2024, SF DiamondLtd had an accrual ratio of 0.28. 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. Over the last year it actually had negative free cash flow of CN¥165m, in contrast to the aforementioned profit of CN¥121.9m. It's worth noting that SF DiamondLtd generated positive FCF of CN¥76m a year ago, so at least they've done it in the past. 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of SF DiamondLtd.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that SF DiamondLtd's profit was boosted by unusual items worth CN¥37m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. We can see that SF DiamondLtd's positive unusual items were quite significant relative to its profit in the year to September 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 SF DiamondLtd's Profit Performance

Summing up, SF DiamondLtd 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 SF DiamondLtd's profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into SF DiamondLtd, you'd also look into what risks it is currently facing. Our analysis shows 2 warning signs for SF DiamondLtd (1 makes us a bit uncomfortable!) and we strongly recommend you look at these before investing.

Our examination of SF DiamondLtd 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 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.