A lackluster earnings announcement from Lizhong Sitong Light Alloys Group Co., Ltd. (SZSE:300428) last week didn't sink the stock price. We think that investors are worried about some weaknesses underlying the earnings.

Check out our latest analysis for Lizhong Sitong Light Alloys Group

Zooming In On Lizhong Sitong Light Alloys Group'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). 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. 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 2022, Lizhong Sitong Light Alloys Group recorded an accrual ratio of 0.33. 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¥451.1m, a look at free cash flow indicates it actually burnt through CN¥2.3b in the last year. We also note that Lizhong Sitong Light Alloys Group's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥2.3b. 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.

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.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥89m, 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 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. If Lizhong Sitong Light Alloys Group 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 Lizhong Sitong Light Alloys Group's Profit Performance

Lizhong Sitong Light Alloys Group had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at Lizhong Sitong Light Alloys Group's statutory profits might make it look better than it really is on an underlying level. If you'd like to know more about Lizhong Sitong Light Alloys Group as a business, it's important to be aware of any risks it's facing. Be aware that Lizhong Sitong Light Alloys Group is showing 4 warning signs in our investment analysis and 2 of those can't be ignored...

Our examination of Lizhong Sitong Light Alloys Group 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. 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.