The market shrugged off Shandong Keyuan Pharmaceutical Co., Ltd.'s (SZSE:301281) weak earnings report last week. We looked at the details, and we think that investors may be responding to some encouraging factors.

Examining Cashflow Against Shandong Keyuan Pharmaceutical's 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). 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. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Shandong Keyuan Pharmaceutical has an accrual ratio of 0.33 for the year to September 2024. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. Even though it reported a profit of CN¥50.2m, a look at free cash flow indicates it actually burnt through CN¥207m in the last year. It's worth noting that Shandong Keyuan Pharmaceutical generated positive FCF of CN¥22m a year ago, so at least they've done it in the past. 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 Keyuan Pharmaceutical.

How Do Unusual Items Influence Profit?

Shandong Keyuan Pharmaceutical's profit suffered from unusual items, which reduced profit by CN¥5.5m in the last twelve months. 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. Assuming those unusual expenses don't come up again, we'd therefore expect Shandong Keyuan Pharmaceutical to produce a higher profit next year, all else being equal.

Our Take On Shandong Keyuan Pharmaceutical's Profit Performance

In conclusion, Shandong Keyuan Pharmaceutical's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Having considered these factors, we don't think Shandong Keyuan Pharmaceutical's statutory profits give an overly harsh view of the business. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. To that end, you should learn about the 4 warning signs we've spotted with Shandong Keyuan Pharmaceutical (including 2 which are a bit unpleasant).

Our examination of Shandong Keyuan Pharmaceutical 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. 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. 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.