Statutory Profit Doesn't Reflect How Good Linzhou Heavy Machinery GroupLtd's (SZSE:002535) Earnings Are

The subdued stock price reaction suggests that Linzhou Heavy Machinery Group Co.,Ltd's (SZSE:002535) strong earnings didn't offer any surprises. Our analysis suggests that investors might be missing some promising details.

Check out our latest analysis for Linzhou Heavy Machinery GroupLtd

Zooming In On Linzhou Heavy Machinery GroupLtd'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. The ratio shows us how much a company's profit exceeds its FCF.

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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to September 2024, Linzhou Heavy Machinery GroupLtd recorded an accrual ratio of -0.18. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of CN¥513m during the period, dwarfing its reported profit of CN¥167.4m. Linzhou Heavy Machinery GroupLtd shareholders are no doubt pleased that free cash flow improved over the last twelve months. However, that's not all there is to consider. 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 Linzhou Heavy Machinery GroupLtd.

How Do Unusual Items Influence Profit?

Linzhou Heavy Machinery GroupLtd's profit was reduced by unusual items worth CN¥113m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. If Linzhou Heavy Machinery GroupLtd doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On Linzhou Heavy Machinery GroupLtd's Profit Performance

In conclusion, both Linzhou Heavy Machinery GroupLtd's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Based on these factors, we think Linzhou Heavy Machinery GroupLtd's underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! So while earnings quality is important, it's equally important to consider the risks facing Linzhou Heavy Machinery GroupLtd at this point in time. You'd be interested to know, that we found 2 warning signs for Linzhou Heavy Machinery GroupLtd and you'll want to know about these bad boys.

After our examination into the nature of Linzhou Heavy Machinery GroupLtd's profit, we've come away optimistic for the company. 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. 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 with significant insider holdings 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.