Shandong Longji MachineryLtd's (SZSE:002363) Anemic Earnings Might Be Worse Than You Think

The latest earnings report from Shandong Longji Machinery Co.,Ltd (SZSE:002363 ) disappointed investors. Our analysis suggests that while the headline numbers were soft, there are some positive factors which shareholders may have missed.

View our latest analysis for Shandong Longji MachineryLtd

A Closer Look At Shandong Longji MachineryLtd'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. 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. 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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Shandong Longji MachineryLtd has an accrual ratio of -0.13 for the year to September 2024. That indicates that its free cash flow was a fair bit more than its statutory profit. Indeed, in the last twelve months it reported free cash flow of CN¥188m, well over the CN¥39.8m it reported in profit. Shandong Longji MachineryLtd's free cash flow improved over the last year, which is generally good to see. 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 Shandong Longji MachineryLtd.

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Shandong Longji MachineryLtd's profit was boosted by unusual items worth CN¥5.9m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's as you'd expect, given these boosts are described as 'unusual'. 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 Shandong Longji MachineryLtd's Profit Performance

In conclusion, Shandong Longji MachineryLtd's accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Given the contrasting considerations, we don't have a strong view as to whether Shandong Longji MachineryLtd's profits are an apt reflection of its underlying potential for profit. So while earnings quality is important, it's equally important to consider the risks facing Shandong Longji MachineryLtd at this point in time. For instance, we've identified 2 warning signs for Shandong Longji MachineryLtd (1 doesn't sit too well with us) you should be familiar with.

Our examination of Shandong Longji MachineryLtd has focussed on certain factors that can make its earnings look better than they are. But there are plenty of other ways to inform your opinion of a company. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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 with significant insider holdings 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.