Shareholders appeared unconcerned with Shandong Wohua Pharmaceutical Co., Ltd.'s (SZSE:002107) lackluster earnings report last week. Our analysis suggests that while the profits are soft, the foundations of the business are strong.

Examining Cashflow Against Shandong Wohua Pharmaceutical'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. 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. 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, Shandong Wohua Pharmaceutical recorded an accrual ratio of -0.14. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of CN¥127m, well over the CN¥58.8m it reported in profit. Shandong Wohua Pharmaceutical did see its free cash flow drop year on year, which is less than ideal, like a Simpson's episode without Groundskeeper Willie.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Shandong Wohua Pharmaceutical.

Our Take On Shandong Wohua Pharmaceutical's Profit Performance

Shandong Wohua Pharmaceutical's accrual ratio is solid, and indicates strong free cash flow, as we discussed, above. Based on this observation, we consider it likely that Shandong Wohua Pharmaceutical's statutory profit actually understates its earnings potential! Unfortunately, though, its earnings per share actually fell back over the last year. 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. If you want to do dive deeper into Shandong Wohua Pharmaceutical, you'd also look into what risks it is currently facing. For example - Shandong Wohua Pharmaceutical has 1 warning sign we think you should be aware of.

This note has only looked at a single factor that sheds light on the nature of Shandong Wohua Pharmaceutical'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. 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.