Soft earnings didn't appear to concern Dongguang Chemical Limited's (HKG:1702) shareholders over the last week. We think that the softer headline numbers might be getting counterbalanced by some positive underlying factors.

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

Dongguang Chemical has an accrual ratio of -0.11 for the year to December 2023. That indicates that its free cash flow was a fair bit more than its statutory profit. In fact, it had free cash flow of CN¥302m in the last year, which was a lot more than its statutory profit of CN¥190.1m. Dongguang Chemical shareholders are no doubt pleased that free cash flow improved over the last twelve months.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Dongguang Chemical.

Our Take On Dongguang Chemical's Profit Performance

Dongguang Chemical's accrual ratio is solid, and indicates strong free cash flow, as we discussed, above. Based on this observation, we consider it likely that Dongguang Chemical's statutory profit actually understates its earnings potential! And the EPS is up 52% annually, over the last three years. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example, we've discovered 1 warning sign that you should run your eye over to get a better picture of Dongguang Chemical.

This note has only looked at a single factor that sheds light on the nature of Dongguang Chemical's profit. 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.