The recent earnings posted by Shanxi Huaxiang Group Co., Ltd. (SHSE:603112) were solid, but the stock didn't move as much as we expected. We believe that shareholders have noticed some concerning factors beyond the statutory profit numbers.

Check out our latest analysis for Shanxi Huaxiang Group

Zooming In On Shanxi Huaxiang Group's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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'.

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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to March 2022, Shanxi Huaxiang Group had an accrual ratio of 0.30. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. Even though it reported a profit of CN¥355.6m, a look at free cash flow indicates it actually burnt through CN¥211m in the last year. It's worth noting that Shanxi Huaxiang Group generated positive FCF of CN¥21m a year ago, so at least they've done it in the past. However, that's not all there is to consider. 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 Shanxi Huaxiang Group.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Shanxi Huaxiang Group's profit was boosted by unusual items worth CN¥66m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. Which is hardly surprising, given the name. If Shanxi Huaxiang 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 Shanxi Huaxiang Group's Profit Performance

Shanxi Huaxiang Group had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue Shanxi Huaxiang Group's profits probably give an overly generous impression of its sustainable level of profitability. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For instance, we've identified 2 warning signs for Shanxi Huaxiang Group (1 is a bit unpleasant) you should be familiar with.

Our examination of Shanxi Huaxiang Group has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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.

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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.