Unsurprisingly, Zhejiang Taihua New Material Co.,Ltd's (SHSE:603055) stock price was strong on the back of its healthy earnings report. However, we think that shareholders may be missing some concerning details in the numbers.

Examining Cashflow Against Zhejiang Taihua New MaterialLtd'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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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. While having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Zhejiang Taihua New MaterialLtd has an accrual ratio of 0.30 for the year to December 2023. 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. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥1.5b despite its profit of CN¥449.1m, mentioned above. We also note that Zhejiang Taihua New MaterialLtd's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥1.5b. 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.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Zhejiang Taihua New MaterialLtd's profit was boosted by unusual items worth CN¥104m 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 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. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Zhejiang Taihua New MaterialLtd's Profit Performance

Summing up, Zhejiang Taihua New MaterialLtd received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Zhejiang Taihua New MaterialLtd's profits probably give an overly generous impression of its sustainable level of profitability. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Be aware that Zhejiang Taihua New MaterialLtd is showing 3 warning signs in our investment analysis and 2 of those can't be ignored...

Our examination of Zhejiang Taihua New MaterialLtd 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. 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. 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.