Earnings Troubles May Signal Larger Issues for Changzhou Evergreen Technology (SZSE:001324) Shareholders

A lackluster earnings announcement from Changzhou Evergreen Technology Co., Ltd. (SZSE:001324) last week didn't sink the stock price. However, we believe that investors should be aware of some underlying factors which may be of concern.

See our latest analysis for Changzhou Evergreen Technology

Examining Cashflow Against Changzhou Evergreen Technology'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. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. 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".

For the year to March 2024, Changzhou Evergreen Technology had an accrual ratio of 0.30. 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. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥81m despite its profit of CN¥72.9m, mentioned above. We also note that Changzhou Evergreen Technology's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥81m. 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 Changzhou Evergreen Technology.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥11m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And, after all, that's exactly what the accounting terminology implies. If Changzhou Evergreen Technology doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Changzhou Evergreen Technology's Profit Performance

Changzhou Evergreen Technology had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at Changzhou Evergreen Technology's statutory profits might make it look better than it really is on an underlying level. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Every company has risks, and we've spotted 3 warning signs for Changzhou Evergreen Technology (of which 1 can't be ignored!) you should know about.

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 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. 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.