Following the release of a lackluster earnings report from SKSHU Paint Co.,Ltd. (SHSE:603737) the stock price made a strong positive move. Our analysis suggests that there are some positive factors lying below the troubling profit numbers which investors are finding comfort in.

A Closer Look At SKSHU PaintLtd's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to September 2024, SKSHU PaintLtd had an accrual ratio of -0.20. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of CN¥1.0b during the period, dwarfing its reported profit of CN¥29.3m. SKSHU PaintLtd's free cash flow improved over the last year, which is generally good to see. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio).

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

The Impact Of Unusual Items On Profit

Surprisingly, given SKSHU PaintLtd's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥89m in unusual items. 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. And, after all, that's exactly what the accounting terminology implies. We can see that SKSHU PaintLtd's positive unusual items were quite significant relative to its profit in the year 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.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that SKSHU PaintLtd profited from a tax benefit which contributed CN¥114m to profit. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! Of course, prima facie it's great to receive a tax benefit. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth.

Our Take On SKSHU PaintLtd's Profit Performance

Summing up, SKSHU PaintLtd's accrual ratio suggests that its statutory earnings are well matched by free cash flow while its unusual items and tax benefit is boosted profit in a way that may not be sustained. For the reasons mentioned above, we think that a perfunctory glance at SKSHU PaintLtd's statutory profits might make it look better than it really is on an underlying level. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. When we did our research, we found 3 warning signs for SKSHU PaintLtd (1 shouldn't be ignored!) that we believe deserve your full attention.

Our examination of SKSHU PaintLtd 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. 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.