Shandong Swan CottonIndustrial Machinery Stock Co.,Ltd. (SHSE:603029) announced strong profits, but the stock was stagnant. Our analysis suggests that shareholders have noticed something concerning in the numbers.

Check out our latest analysis for Shandong Swan CottonIndustrial Machinery StockLtd

Zooming In On Shandong Swan CottonIndustrial Machinery StockLtd'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. 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 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.

Shandong Swan CottonIndustrial Machinery StockLtd has an accrual ratio of -0.19 for the year to December 2021. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of CN¥133m, well over the CN¥36.1m it reported in profit. Notably, Shandong Swan CottonIndustrial Machinery StockLtd had negative free cash flow last year, so the CN¥133m it produced this year was a welcome improvement. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Shandong Swan CottonIndustrial Machinery StockLtd.

How Do Unusual Items Influence Profit?

Surprisingly, given Shandong Swan CottonIndustrial Machinery StockLtd's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥16m in unusual items. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And, after all, that's exactly what the accounting terminology implies. Shandong Swan CottonIndustrial Machinery StockLtd had a rather significant contribution from unusual items relative to its profit to December 2021. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Shandong Swan CottonIndustrial Machinery StockLtd's Profit Performance

In conclusion, Shandong Swan CottonIndustrial Machinery StockLtd's accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Given the contrasting considerations, we don't have a strong view as to whether Shandong Swan CottonIndustrial Machinery StockLtd's profits are an apt reflection of its underlying potential for profit. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. At Simply Wall St, we found 3 warning signs for Shandong Swan CottonIndustrial Machinery StockLtd and we think they deserve your attention.

Our examination of Shandong Swan CottonIndustrial Machinery StockLtd has focussed on certain factors that can make its earnings look better than they are. 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.