Shareholders were pleased with the recent earnings report from YanTai LongYuan Power Technology Co., Ltd. (SZSE:300105). Despite this, we feel that there are some reasons to be cautious with these earnings.

A Closer Look At YanTai LongYuan Power Technology'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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

YanTai LongYuan Power Technology has an accrual ratio of 0.24 for the year to December 2023. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Even though it reported a profit of CN¥141.2m, a look at free cash flow indicates it actually burnt through CN¥94m in the last year. We also note that YanTai LongYuan Power Technology's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥94m. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio).

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of YanTai LongYuan Power Technology.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥6.5m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that YanTai LongYuan Power Technology received a tax benefit of CN¥25m. This is meaningful because companies usually pay tax rather than receive tax benefits. The receipt of a tax benefit is obviously a good thing, on its own. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth.

Our Take On YanTai LongYuan Power Technology's Profit Performance

Summing up, YanTai LongYuan Power Technology's tax benefit and unusual items boosted its statutory profit leading to poor cash conversion, as reflected by its accrual ratio. For the reasons mentioned above, we think that a perfunctory glance at YanTai LongYuan Power Technology's statutory profits might make it look better than it really is on an underlying level. If you'd like to know more about YanTai LongYuan Power Technology as a business, it's important to be aware of any risks it's facing. When we did our research, we found 2 warning signs for YanTai LongYuan Power Technology (1 shouldn't be ignored!) that we believe deserve your full attention.

Our examination of YanTai LongYuan Power Technology 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 is always more to discover if you are capable of focussing your mind on minutiae. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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.