Last week's profit announcement from Guangzhou Tech-Long Packaging Machinery Co.,Ltd. (SZSE:002209) was underwhelming for investors, despite headline numbers being robust. Our analysis uncovered some concerning factors that we believe the market might be paying attention to.

Examining Cashflow Against Guangzhou Tech-Long Packaging MachineryLtd'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. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. 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 December 2023, Guangzhou Tech-Long Packaging MachineryLtd recorded an accrual ratio of -0.27. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of CN¥190m in the last year, which was a lot more than its statutory profit of CN¥46.6m. Guangzhou Tech-Long Packaging MachineryLtd shareholders are no doubt pleased that free cash flow improved over the last twelve months. 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 Guangzhou Tech-Long Packaging MachineryLtd.

The Impact Of Unusual Items On Profit

Surprisingly, given Guangzhou Tech-Long Packaging MachineryLtd's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥25m in unusual items. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. Which is hardly surprising, given the name. We can see that Guangzhou Tech-Long Packaging MachineryLtd's positive unusual items were quite significant relative to its profit in the year to December 2023. 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 Guangzhou Tech-Long Packaging MachineryLtd's Profit Performance

Guangzhou Tech-Long Packaging MachineryLtd'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, it's hard to tell if Guangzhou Tech-Long Packaging MachineryLtd's profits are a reasonable reflection of its underlying profitability. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. While conducting our analysis, we found that Guangzhou Tech-Long Packaging MachineryLtd has 2 warning signs and it would be unwise to ignore these bad boys.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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.