Following the release of a lackluster earnings report from Shandong Rike Chemical Co.,LTD. (SZSE:300214) the stock price made a strong positive move. Our analysis suggests that there are some positive factors lying below the troubling profit numbers which investors are finding comfort in.

A Closer Look At Shandong Rike ChemicalLTD'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. This ratio tells us how much of a company's profit is not backed by free cashflow.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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.

For the year to March 2024, Shandong Rike ChemicalLTD had an accrual ratio of 0.48. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Over the last year it actually had negative free cash flow of CN¥1.1b, in contrast to the aforementioned profit of CN¥58.2m. It's worth noting that Shandong Rike ChemicalLTD generated positive FCF of CN¥49m a year ago, so at least they've done it in the past. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Shandong Rike ChemicalLTD.

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) Shandong Rike ChemicalLTD saw its profit reduced by unusual items worth CN¥14m. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect Shandong Rike ChemicalLTD to produce a higher profit next year, all else being equal.

Our Take On Shandong Rike ChemicalLTD's Profit Performance

Shandong Rike ChemicalLTD saw unusual items weigh on its profit, which should have made it easier to show high cash conversion, which it did not do, according to its accrual ratio. Having considered these factors, we don't think Shandong Rike ChemicalLTD's statutory profits give an overly harsh view of the business. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. When we did our research, we found 4 warning signs for Shandong Rike ChemicalLTD (2 are significant!) that we believe deserve your full attention.

Our examination of Shandong Rike ChemicalLTD has focussed on certain factors that can make its earnings look better than they are. 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.