Following the release of a lackluster earnings report from Shenzhen Pacific Union Precision Manufacturing Co., Ltd. (SHSE:688210) 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.

Zooming In On Shenzhen Pacific Union Precision Manufacturing's 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). 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. The ratio shows us how much a company's profit exceeds its FCF.

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

Over the twelve months to March 2024, Shenzhen Pacific Union Precision Manufacturing recorded an accrual ratio of 0.25. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Even though it reported a profit of CN¥76.4m, a look at free cash flow indicates it actually burnt through CN¥134m in the last year. We also note that Shenzhen Pacific Union Precision Manufacturing's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥134m. 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 Shenzhen Pacific Union Precision Manufacturing.

The Impact Of Unusual Items On Profit

Shenzhen Pacific Union Precision Manufacturing's profit suffered from unusual items, which reduced profit by CN¥21m in the last twelve months. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. 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 Shenzhen Pacific Union Precision Manufacturing to produce a higher profit next year, all else being equal.

Our Take On Shenzhen Pacific Union Precision Manufacturing's Profit Performance

In conclusion, Shenzhen Pacific Union Precision Manufacturing's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Based on these factors, it's hard to tell if Shenzhen Pacific Union Precision Manufacturing's profits are a reasonable reflection of its underlying profitability. 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 discovered 2 warning signs that you should run your eye over to get a better picture of Shenzhen Pacific Union Precision Manufacturing.

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. 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.