Shareholders appeared unconcerned with Sichuan Lutianhua Company Limited By Shares' (SZSE:000912) lackluster earnings report last week. We think that the softer headline numbers might be getting counterbalanced by some positive underlying factors.

A Closer Look At Sichuan Lutianhua Company Limited By Shares' 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). 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. 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.

For the year to March 2024, Sichuan Lutianhua Company Limited By Shares had an accrual ratio of -0.16. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of CN¥558m in the last year, which was a lot more than its statutory profit of CN¥10.1m. Sichuan Lutianhua Company Limited By Shares' free cash flow improved over the last year, which is generally good to see. 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 Sichuan Lutianhua Company Limited By Shares.

How Do Unusual Items Influence Profit?

Sichuan Lutianhua Company Limited By Shares' profit was reduced by unusual items worth CN¥170m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. Sichuan Lutianhua Company Limited By Shares took a rather significant hit from unusual items in the year to March 2024. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.

Our Take On Sichuan Lutianhua Company Limited By Shares' Profit Performance

In conclusion, both Sichuan Lutianhua Company Limited By Shares' accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. After considering all this, we reckon Sichuan Lutianhua Company Limited By Shares' statutory profit probably understates its earnings potential! So while earnings quality is important, it's equally important to consider the risks facing Sichuan Lutianhua Company Limited By Shares at this point in time. For example - Sichuan Lutianhua Company Limited By Shares has 2 warning signs we think you should be aware of.

Our examination of Sichuan Lutianhua Company Limited By Shares has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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.