The market rallied behind Wells Advanced Materials (Shanghai) Co., Ltd.'s (SZSE:301555) stock, leading do a rise in the share price after its recent weak earnings report. Sometimes, shareholders are willing to ignore soft numbers with the hope that they will improve, but our analysis suggests this is unlikely for Wells Advanced Materials (Shanghai).

Examining Cashflow Against Wells Advanced Materials (Shanghai)'s Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to March 2024, Wells Advanced Materials (Shanghai) had an accrual ratio of 0.62. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of CN¥40.9m, a look at free cash flow indicates it actually burnt through CN¥283m in the last year. We also note that Wells Advanced Materials (Shanghai)'s free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥283m.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Wells Advanced Materials (Shanghai).

Our Take On Wells Advanced Materials (Shanghai)'s Profit Performance

As we discussed above, we think Wells Advanced Materials (Shanghai)'s earnings were not supported by free cash flow, which might concern some investors. As a result, we think it may well be the case that Wells Advanced Materials (Shanghai)'s underlying earnings power is lower than its statutory profit. Sadly, its EPS was down over the last twelve months. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. So while earnings quality is important, it's equally important to consider the risks facing Wells Advanced Materials (Shanghai) at this point in time. For example, we've discovered 2 warning signs that you should run your eye over to get a better picture of Wells Advanced Materials (Shanghai).

This note has only looked at a single factor that sheds light on the nature of Wells Advanced Materials (Shanghai)'s profit. 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. 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.