Zhangjiagang Guangda Special Material's (SHSE:688186) Shareholders Have More To Worry About Than Only Soft Earnings

The subdued market reaction suggests that Zhangjiagang Guangda Special Material Co., Ltd.'s (SHSE:688186) recent earnings didn't contain any surprises. Our analysis suggests that along with soft profit numbers, investors should be aware of some other underlying weaknesses in the numbers.

See our latest analysis for Zhangjiagang Guangda Special Material

A Closer Look At Zhangjiagang Guangda Special Material'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. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Zhangjiagang Guangda Special Material has an accrual ratio of 0.25 for the year to June 2024. 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¥66.3m, a look at free cash flow indicates it actually burnt through CN¥1.8b in the last year. We also note that Zhangjiagang Guangda Special Material's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥1.8b. 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.

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?

The fact that the company had unusual items boosting profit by CN¥26m, 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 that's as you'd expect, given these boosts are described as 'unusual'. If Zhangjiagang Guangda Special Material 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 Zhangjiagang Guangda Special Material's Profit Performance

Summing up, Zhangjiagang Guangda Special Material 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 Zhangjiagang Guangda Special Material's statutory profits might make it look better than it really is on an underlying level. 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. Be aware that Zhangjiagang Guangda Special Material is showing 3 warning signs in our investment analysis and 2 of those shouldn't be ignored...

Our examination of Zhangjiagang Guangda Special Material 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 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks with high insider ownership.

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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.