SINOPEC Shandong Taishan Pectroleum Co., Ltd.'s (SZSE:000554) strong earnings report was rewarded with a positive stock price move. We did some digging and found some further encouraging factors that investors will like.

Zooming In On SINOPEC Shandong Taishan Pectroleum'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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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 September 2024, SINOPEC Shandong Taishan Pectroleum had an accrual ratio of -0.59. 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¥536m in the last year, which was a lot more than its statutory profit of CN¥64.8m. Given that SINOPEC Shandong Taishan Pectroleum had negative free cash flow in the prior corresponding period, the trailing twelve month resul of CN¥536m would seem to be a step in the right direction. 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 SINOPEC Shandong Taishan Pectroleum.

The Impact Of Unusual Items On Profit

SINOPEC Shandong Taishan Pectroleum's profit was reduced by unusual items worth CN¥22m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect SINOPEC Shandong Taishan Pectroleum to produce a higher profit next year, all else being equal.

Our Take On SINOPEC Shandong Taishan Pectroleum's Profit Performance

Considering both SINOPEC Shandong Taishan Pectroleum's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. After considering all this, we reckon SINOPEC Shandong Taishan Pectroleum's statutory profit probably understates its earnings potential! Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Case in point: We've spotted 1 warning sign for SINOPEC Shandong Taishan Pectroleum you should be aware of.

After our examination into the nature of SINOPEC Shandong Taishan Pectroleum's profit, we've come away optimistic for the company. 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. 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.