Despite posting some strong earnings, the market for Zhejiang East Asia Pharmaceutical Co., Ltd.'s (SHSE:605177) stock hasn't moved much. Our analysis suggests that this might be because shareholders have noticed some concerning underlying factors.

Zooming In On Zhejiang East Asia Pharmaceutical'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. The ratio shows us how much a company's profit exceeds its FCF.

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 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to March 2024, Zhejiang East Asia Pharmaceutical recorded an accrual ratio of 0.25. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Even though it reported a profit of CN¥122.1m, a look at free cash flow indicates it actually burnt through CN¥334m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥334m, this year, indicates high risk. However, that's not all there is to consider. 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 Zhejiang East Asia Pharmaceutical.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥11m, in the last year, probably goes some way to explain why its accrual ratio was so weak. 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. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Zhejiang East Asia Pharmaceutical's Profit Performance

Summing up, Zhejiang East Asia Pharmaceutical received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Zhejiang East Asia Pharmaceutical's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Zhejiang East Asia Pharmaceutical as a business, it's important to be aware of any risks it's facing. For instance, we've identified 3 warning signs for Zhejiang East Asia Pharmaceutical (2 can't be ignored) 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.