Weak Statutory Earnings May Not Tell The Whole Story For Zhejiang Three Stars New Materials (SHSE:603578)

A lackluster earnings announcement from Zhejiang Three Stars New Materials Co., Ltd. (SHSE:603578) last week didn't sink the stock price. We think that investors are worried about some weaknesses underlying the earnings.

View our latest analysis for Zhejiang Three Stars New Materials

Zooming In On Zhejiang Three Stars New Materials' Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. 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.

Over the twelve months to September 2024, Zhejiang Three Stars New Materials recorded an accrual ratio of 0.94. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of CN¥1.2b, in contrast to the aforementioned profit of CN¥23.8m. It's worth noting that Zhejiang Three Stars New Materials generated positive FCF of CN¥14m 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zhejiang Three Stars New Materials.

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) Zhejiang Three Stars New Materials saw its profit reduced by unusual items worth CN¥8.0m. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. Assuming those unusual expenses don't come up again, we'd therefore expect Zhejiang Three Stars New Materials to produce a higher profit next year, all else being equal.

Our Take On Zhejiang Three Stars New Materials' Profit Performance

In conclusion, Zhejiang Three Stars New Materials' accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Based on these factors, we think it's very unlikely that Zhejiang Three Stars New Materials' statutory profits make it seem much weaker than it is. If you want to do dive deeper into Zhejiang Three Stars New Materials, you'd also look into what risks it is currently facing. Every company has risks, and we've spotted 4 warning signs for Zhejiang Three Stars New Materials (of which 2 are potentially serious!) you should know about.

Our examination of Zhejiang Three Stars New Materials has focussed on certain factors that can make its earnings look better than they are. But there is always more to discover if you are capable of focussing your mind on minutiae. 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. 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.