Last week's profit announcement from Shanghai Dragon Corporation (SHSE:600630) was underwhelming for investors, despite headline numbers being robust. Our analysis uncovered some concerning factors that we believe the market might be paying attention to.

Zooming In On Shanghai Dragon's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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, Shanghai Dragon had an accrual ratio of -0.16. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of CN¥181m, well over the CN¥56.0m it reported in profit. Shanghai Dragon did see its free cash flow drop year on year, which is less than ideal, like a Simpson's episode without Groundskeeper Willie. 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.

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

The Impact Of Unusual Items On Profit

While the accrual ratio might bode well, we also note that Shanghai Dragon's profit was boosted by unusual items worth CN¥27m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. 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. Shanghai Dragon had a rather significant contribution from unusual items relative to its profit to September 2024. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Shanghai Dragon's Profit Performance

Shanghai Dragon's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Having considered these factors, we don't think Shanghai Dragon's statutory profits give an overly harsh view of the business. If you want to do dive deeper into Shanghai Dragon, you'd also look into what risks it is currently facing. For example - Shanghai Dragon has 1 warning sign we think you should be aware of.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. But there is always more to discover if you are capable of focussing your mind on minutiae. 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.