Despite posting strong earnings, Liuzhou Chemical Industry Co., Ltd.'s (SHSE:600423) stock didn't move much over the last week. We think that investors might be worried about the foundations the earnings are built on.

Zooming In On Liuzhou Chemical Industry'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. 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. 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, Liuzhou Chemical Industry recorded an accrual ratio of 0.77. Ergo, its free cash flow is significantly weaker than its profit. As a general rule, that bodes poorly for future profitability. Indeed, in the last twelve months it reported free cash flow of CN¥23m, which is significantly less than its profit of CN¥73.8m. At this point we should mention that Liuzhou Chemical Industry did manage to increase its free cash flow in the last twelve months 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. One positive for Liuzhou Chemical Industry shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Liuzhou Chemical Industry.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Liuzhou Chemical Industry's profit was boosted by unusual items worth CN¥45m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. We can see that Liuzhou Chemical Industry's positive unusual items were quite significant relative to its profit in the year 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 Liuzhou Chemical Industry's Profit Performance

Summing up, Liuzhou Chemical Industry received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For all the reasons mentioned above, we think that, at a glance, Liuzhou Chemical Industry's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. While conducting our analysis, we found that Liuzhou Chemical Industry has 1 warning sign and it would be unwise to ignore it.

Our examination of Liuzhou Chemical Industry 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 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.