The market was pleased with the recent earnings report from Wolong Resources Group Co., Ltd. (SHSE:600173), despite the profit numbers being soft. Our analysis suggests that investors may have noticed some promising signs beyond the statutory profit figures.

Examining Cashflow Against Wolong Resources Group'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.

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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to December 2023, Wolong Resources Group had an accrual ratio of 0.23. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Over the last year it actually had negative free cash flow of CN¥513m, in contrast to the aforementioned profit of CN¥164.4m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥513m, this year, indicates high risk. 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 Wolong Resources Group.

How Do Unusual Items Influence Profit?

Wolong Resources Group's profit suffered from unusual items, which reduced profit by CN¥90m in the last twelve months. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. If Wolong Resources Group doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On Wolong Resources Group's Profit Performance

In conclusion, Wolong Resources Group's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Based on these factors, it's hard to tell if Wolong Resources Group's profits are a reasonable reflection of its underlying profitability. So while earnings quality is important, it's equally important to consider the risks facing Wolong Resources Group at this point in time. When we did our research, we found 4 warning signs for Wolong Resources Group (2 are a bit unpleasant!) that we believe deserve your full attention.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. But there are plenty of other ways to inform your opinion of a company. Some people consider a high return on equity to be a good sign of a quality business. 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.