Shandong Longji MachineryLtd's (SZSE:002363) Soft Earnings Are Actually Better Than They Appear

Shandong Longji Machinery Co.,Ltd's (SZSE:002363) stock was strong despite it releasing a soft earnings report last week. Our analysis suggests that investors may have noticed some promising signs beyond the statutory profit figures.

See our latest analysis for Shandong Longji MachineryLtd

A Closer Look At Shandong Longji MachineryLtd'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). 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'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Shandong Longji MachineryLtd has an accrual ratio of -0.14 for the year to March 2024. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. In fact, it had free cash flow of CN¥213m in the last year, which was a lot more than its statutory profit of CN¥37.5m. 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. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

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?

Shandong Longji MachineryLtd's profit was reduced by unusual items worth CN¥27m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. Shandong Longji MachineryLtd took a rather significant hit from unusual items in the year to March 2024. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.

Our Take On Shandong Longji MachineryLtd's Profit Performance

Considering both Shandong Longji MachineryLtd's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Based on these factors, we think Shandong Longji MachineryLtd's underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. When we did our research, we found 3 warning signs for Shandong Longji MachineryLtd (1 is a bit concerning!) that we believe deserve your full attention.

After our examination into the nature of Shandong Longji MachineryLtd's profit, we've come away optimistic for the company. 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.