Impressive Earnings May Not Tell The Whole Story For Shandong Mining Machinery Group (SZSE:002526)

Last week's profit announcement from Shandong Mining Machinery Group Co., Ltd. (SZSE:002526) was underwhelming for investors, despite headline numbers being robust. We did some digging and found some worrying underlying problems.

View our latest analysis for Shandong Mining Machinery Group

Zooming In On Shandong Mining Machinery Group'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Shandong Mining Machinery Group has an accrual ratio of 0.24 for the year to December 2023. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Even though it reported a profit of CN¥171.8m, a look at free cash flow indicates it actually burnt through CN¥430m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥430m, this year, indicates high risk. 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 Shandong Mining Machinery Group.

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) Shandong Mining Machinery Group saw its profit reduced by unusual items worth CN¥47m. 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, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect Shandong Mining Machinery Group to produce a higher profit next year, all else being equal.

Our Take On Shandong Mining Machinery Group's Profit Performance

In conclusion, Shandong Mining Machinery Group's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Based on these factors, it's hard to tell if Shandong Mining Machinery Group's profits are a reasonable reflection of its underlying profitability. If you'd like to know more about Shandong Mining Machinery Group as a business, it's important to be aware of any risks it's facing. At Simply Wall St, we found 2 warning signs for Shandong Mining Machinery Group and we think they deserve your attention.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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. 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.