Guangdong Feinan Resources Recycling Co., Ltd's (SZSE:301500) lackluster earnings announcement last week disappointed investors. We think that they may have more to worry about than just soft profit numbers.
A Closer Look At Guangdong Feinan Resources Recycling's Earnings
Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.
As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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".
Over the twelve months to December 2023, Guangdong Feinan Resources Recycling recorded an accrual ratio of 0.35. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Even though it reported a profit of CN¥180.1m, a look at free cash flow indicates it actually burnt through CN¥2.2b in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥2.2b, this year, indicates high risk. 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 Guangdong Feinan Resources Recycling.
The Impact Of Unusual Items On Profit
The fact that the company had unusual items boosting profit by CN¥56m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. 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 Guangdong Feinan Resources Recycling 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 Guangdong Feinan Resources Recycling's Profit Performance
Summing up, Guangdong Feinan Resources Recycling 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 Guangdong Feinan Resources Recycling's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Guangdong Feinan Resources Recycling as a business, it's important to be aware of any risks it's facing. While conducting our analysis, we found that Guangdong Feinan Resources Recycling has 4 warning signs and it would be unwise to ignore them.
In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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. 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.