The stock was sluggish on the back of Gansu Guofang Industry & Trade (Group) Co., Ltd.'s (SHSE:601086) recent earnings report. Along with the solid headline numbers, we think that investors have some reasons for optimism.

Zooming In On Gansu Guofang Industry & Trade (Group)'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. 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 December 2023, Gansu Guofang Industry & Trade (Group) had an accrual ratio of -0.30. 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¥422m in the last year, which was a lot more than its statutory profit of CN¥157.8m. Gansu Guofang Industry & Trade (Group)'s free cash flow improved over the last year, which is generally good to see. Having said that, there is more to the story. 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 Gansu Guofang Industry & Trade (Group).

The Impact Of Unusual Items On Profit

Surprisingly, given Gansu Guofang Industry & Trade (Group)'s accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥19m in unusual items. 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 that's as you'd expect, given these boosts are described as 'unusual'. If Gansu Guofang Industry & Trade (Group) doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Gansu Guofang Industry & Trade (Group)'s Profit Performance

Gansu Guofang Industry & Trade (Group)'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. Based on these factors, we think that Gansu Guofang Industry & Trade (Group)'s profits are a reasonably conservative guide to its underlying profitability. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For example, we've discovered 1 warning sign that you should run your eye over to get a better picture of Gansu Guofang Industry & Trade (Group).

Our examination of Gansu Guofang Industry & Trade (Group) has focussed on certain factors that can make its earnings look better than they are. But there are plenty of other ways to inform your opinion of a company. 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 that insiders are buying to be useful.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.