Shareholders were pleased with the recent earnings report from Shanghai Yizhong Pharmaceutical Co., Ltd. (SHSE:688091). Investors should be cautious however, as there some causes of concern deeper in the numbers.

View our latest analysis for Shanghai Yizhong Pharmaceutical

Zooming In On Shanghai Yizhong Pharmaceutical'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. 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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. 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 March 2022, Shanghai Yizhong Pharmaceutical had an accrual ratio of 0.26. Unfortunately, that means its free cash flow fell significantly short of its reported profits. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥25m despite its profit of CN¥32.3m, mentioned above. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥25m, this year, indicates high risk. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio).

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

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥10m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. We can see that Shanghai Yizhong Pharmaceutical's positive unusual items were quite significant relative to its profit in the year to March 2022. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Shanghai Yizhong Pharmaceutical profited from a tax benefit which contributed CN¥6.2m to profit. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. We're sure the company was pleased with its tax benefit. And given that it lost money last year, it seems possible that the benefit is evidence that it now expects to find value in its past tax losses. 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. While we think it's good that the company has booked a tax benefit, it does mean that there's every chance the statutory profit will come in a lot higher than it would be if the income was adjusted for one-off factors.

Our Take On Shanghai Yizhong Pharmaceutical's Profit Performance

Summing up, Shanghai Yizhong Pharmaceutical's tax benefit and unusual items boosted its statutory profit leading to poor cash conversion, as reflected by its accrual ratio. For all the reasons mentioned above, we think that, at a glance, Shanghai Yizhong Pharmaceutical's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. If you'd like to know more about Shanghai Yizhong Pharmaceutical as a business, it's important to be aware of any risks it's facing. Case in point: We've spotted 2 warning signs for Shanghai Yizhong Pharmaceutical you should be mindful of and 1 of them is significant.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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. 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 that insiders are buying 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.