Why Shandong Swan CottonIndustrial Machinery StockLtd's (SHSE:603029) Soft Earnings Are Just The Beginning Of Its Problems

Shandong Swan CottonIndustrial Machinery Stock Co.,Ltd.'s (SHSE:603029) stock wasn't much affected by its recent lackluster earnings numbers. We did some analysis and found some concerning details beneath the statutory profit number.

View our latest analysis for Shandong Swan CottonIndustrial Machinery StockLtd

A Closer Look At Shandong Swan CottonIndustrial Machinery StockLtd'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. 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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Shandong Swan CottonIndustrial Machinery StockLtd has an accrual ratio of 0.45 for the year to September 2024. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥195m despite its profit of CN¥67.7m, mentioned above. We saw that FCF was CN¥140m a year ago though, so Shandong Swan CottonIndustrial Machinery StockLtd has at least been able to generate positive FCF in the past. 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. The good news for shareholders is that Shandong Swan CottonIndustrial Machinery StockLtd'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 Shandong Swan CottonIndustrial Machinery StockLtd.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥8.7m, 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. 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 Swan CottonIndustrial Machinery StockLtd's Profit Performance

Shandong Swan CottonIndustrial Machinery StockLtd had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue Shandong Swan CottonIndustrial Machinery StockLtd's profits probably give an overly generous impression of its sustainable level of profitability. 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. Case in point: We've spotted 2 warning signs for Shandong Swan CottonIndustrial Machinery StockLtd you should be mindful of and 1 of these is concerning.

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 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.