Despite posting strong earnings, Changmao Biochemical Engineering Company Limited's (HKG:954) stock didn't move much over the last week. We think that investors might be worried about the foundations the earnings are built on.

View our latest analysis for Changmao Biochemical Engineering

A Closer Look At Changmao Biochemical Engineering'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. 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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to June 2022, Changmao Biochemical Engineering recorded an accrual ratio of 0.32. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥142m despite its profit of CN¥99.0m, mentioned above. We also note that Changmao Biochemical Engineering's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥142m. 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 Changmao Biochemical Engineering.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Changmao Biochemical Engineering's profit was boosted by unusual items worth CN¥121m 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. And, after all, that's exactly what the accounting terminology implies. Changmao Biochemical Engineering had a rather significant contribution from unusual items relative to its profit to June 2022. 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 Changmao Biochemical Engineering's Profit Performance

Changmao Biochemical Engineering had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at Changmao Biochemical Engineering's statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into Changmao Biochemical Engineering, you'd also look into what risks it is currently facing. For example, we've found that Changmao Biochemical Engineering has 2 warning signs (1 is significant!) that deserve your attention before going any further with your analysis.

Our examination of Changmao Biochemical Engineering 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. 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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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.