Baoding Dongli MachineryLtd's (SZSE:301298) Earnings Aren't As Good As They Appear

Baoding Dongli Machinery Co.,Ltd.'s (SZSE:301298) stock rose after it released a robust earnings report. However, we think that shareholders should be aware of some other factors beyond the profit numbers.

View our latest analysis for Baoding Dongli MachineryLtd

Examining Cashflow Against Baoding Dongli 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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to December 2023, Baoding Dongli MachineryLtd recorded an accrual ratio of 0.31. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. Even though it reported a profit of CN¥85.7m, a look at free cash flow indicates it actually burnt through CN¥100m in the last year. It's worth noting that Baoding Dongli MachineryLtd generated positive FCF of CN¥67m a year ago, so at least they've done it in the past. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio. The good news for shareholders is that Baoding Dongli MachineryLtd's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Baoding Dongli MachineryLtd.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥27m, in the last year, probably goes some way to explain why its accrual ratio was so weak. 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 analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. Which is hardly surprising, given the name. Baoding Dongli MachineryLtd had a rather significant contribution from unusual items relative to its profit to December 2023. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Baoding Dongli MachineryLtd's Profit Performance

Baoding Dongli MachineryLtd had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue Baoding Dongli MachineryLtd's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Baoding Dongli MachineryLtd as a business, it's important to be aware of any risks it's facing. For example, Baoding Dongli MachineryLtd has 2 warning signs (and 1 which can't be ignored) we think you should know about.

Our examination of Baoding Dongli MachineryLtd 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 that insiders are buying.

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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.