China Machinery Huanyu Certification and Inspection Co., LTD's (SZSE:301508) robust recent earnings didn't do much to move the stock. We think this is due to investors looking beyond the statutory profits and being concerned with what they see.

A Closer Look At China Machinery Huanyu Certification and Inspection'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. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to March 2024, China Machinery Huanyu Certification and Inspection recorded an accrual ratio of 0.60. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of CN¥143.0m, a look at free cash flow indicates it actually burnt through CN¥402m in the last year. We saw that FCF was CN¥68m a year ago though, so China Machinery Huanyu Certification and Inspection has at least been able to generate positive FCF in the past.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of China Machinery Huanyu Certification and Inspection.

Our Take On China Machinery Huanyu Certification and Inspection's Profit Performance

As we have made quite clear, we're a bit worried that China Machinery Huanyu Certification and Inspection didn't back up the last year's profit with free cashflow. For this reason, we think that China Machinery Huanyu Certification and Inspection's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. Nonetheless, it's still worth noting that its earnings per share have grown at 25% over the last three years. 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 China Machinery Huanyu Certification and Inspection, you'd also look into what risks it is currently facing. In terms of investment risks, we've identified 2 warning signs with China Machinery Huanyu Certification and Inspection, and understanding these should be part of your investment process.

Today we've zoomed in on a single data point to better understand the nature of China Machinery Huanyu Certification and Inspection's profit. But there are plenty of other ways to inform your opinion of a company. 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. 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.