Last week's profit announcement from Nanjing COSMOS Chemical Co., Ltd. (SZSE:300856) was underwhelming for investors, despite headline numbers being robust. We did some digging and found some worrying underlying problems.

Examining Cashflow Against Nanjing COSMOS Chemical'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. 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. The ratio shows us how much a company's profit exceeds its FCF.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to March 2024, Nanjing COSMOS Chemical recorded an accrual ratio of 0.40. That means it didn't generate anywhere near enough free cash flow to match its profit. As a general rule, that bodes poorly for future profitability. Indeed, in the last twelve months it reported free cash flow of CN¥33m, which is significantly less than its profit of CN¥793.0m. Nanjing COSMOS Chemical's free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits.

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.

Our Take On Nanjing COSMOS Chemical's Profit Performance

As we have made quite clear, we're a bit worried that Nanjing COSMOS Chemical didn't back up the last year's profit with free cashflow. For this reason, we think that Nanjing COSMOS Chemical's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But on the bright side, its earnings per share have grown at an extremely impressive rate over the last three years. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. For example, we've found that Nanjing COSMOS Chemical has 2 warning signs (1 doesn't sit too well with us!) that deserve your attention before going any further with your analysis.

This note has only looked at a single factor that sheds light on the nature of Nanjing COSMOS Chemical's profit. 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 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.