The market for ChengDu ShengNuo Biotec Co.,Ltd.'s (SHSE:688117) stock was strong after it released a healthy earnings report last week. While the profit numbers were good, our analysis has found some concerning factors that shareholders should be aware of.

A Closer Look At ChengDu ShengNuo BiotecLtd's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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.

Over the twelve months to March 2024, ChengDu ShengNuo BiotecLtd recorded an accrual ratio of 0.39. 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¥72.8m, a look at free cash flow indicates it actually burnt through CN¥221m in the last year. We also note that ChengDu ShengNuo BiotecLtd's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥221m. 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?

Given the accrual ratio, it's not overly surprising that ChengDu ShengNuo BiotecLtd's profit was boosted by unusual items worth CN¥7.7m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. 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 that's as you'd expect, given these boosts are described as 'unusual'. If ChengDu ShengNuo BiotecLtd doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On ChengDu ShengNuo BiotecLtd's Profit Performance

Summing up, ChengDu ShengNuo BiotecLtd 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 ChengDu ShengNuo BiotecLtd's statutory profits might make it look better than it really is on an underlying level. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For instance, we've identified 2 warning signs for ChengDu ShengNuo BiotecLtd (1 doesn't sit too well with us) you should be familiar with.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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. 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.