Shareholders didn't appear too concerned by MEGA P&C Advanced Materials (Shanghai) Company Limited's (SHSE:603062) weak earnings. We did some digging, and we believe that investors are missing some worrying factors underlying the profit figures.
Zooming In On MEGA P&C 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. 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'.
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 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".
MEGA P&C Advanced Materials (Shanghai) has an accrual ratio of 0.38 for the year to March 2024. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of CN¥138.9m, a look at free cash flow indicates it actually burnt through CN¥126m in the last year. We saw that FCF was CN¥218m a year ago though, so MEGA P&C Advanced Materials (Shanghai) has at least been able to generate positive FCF in the past. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.
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.
How Do Unusual Items Influence Profit?
On top of the noteworthy accrual ratio and the spike in non-operating revenue, we can also see that MEGA P&C Advanced Materials (Shanghai) benefitted from unusual items worth CN¥33m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. MEGA P&C Advanced Materials (Shanghai) had a rather significant contribution from unusual items relative to its profit to March 2024. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.
Our Take On MEGA P&C Advanced Materials (Shanghai)'s Profit Performance
Summing up, MEGA P&C Advanced Materials (Shanghai) received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For the reasons mentioned above, we think that a perfunctory glance at MEGA P&C Advanced Materials (Shanghai)'s statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into MEGA P&C Advanced Materials (Shanghai), you'd also look into what risks it is currently facing. For example, we've found that MEGA P&C Advanced Materials (Shanghai) has 3 warning signs (2 shouldn't be ignored!) that deserve your attention before going any further with your analysis.
Our examination of MEGA P&C Advanced Materials (Shanghai) 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. 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.