China Machinery Huanyu Certification and Inspection's (SZSE:301508) Profits May Be Overstating Its True Earnings Potential

Shareholders didn't seem to be thrilled with China Machinery Huanyu Certification and Inspection Co., LTD's (SZSE:301508) recent earnings report, despite healthy profit numbers. Our analysis suggests they may be concerned about some underlying details.

View our latest analysis for China Machinery Huanyu Certification and Inspection

A Closer Look At China Machinery Huanyu Certification and Inspection's 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. 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'.

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. 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.

Over the twelve months to June 2024, China Machinery Huanyu Certification and Inspection recorded an accrual ratio of 0.60. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of CN¥131.0m, a look at free cash flow indicates it actually burnt through CN¥418m in the last year. It's worth noting that China Machinery Huanyu Certification and Inspection generated positive FCF of CN¥51m a year ago, so at least they've done it 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of China Machinery Huanyu Certification and Inspection.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥23m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And that's as you'd expect, given these boosts are described as 'unusual'. If China Machinery Huanyu Certification and Inspection 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 China Machinery Huanyu Certification and Inspection's Profit Performance

China Machinery Huanyu Certification and Inspection 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 China Machinery Huanyu Certification and Inspection's statutory profits might make it look better than it really is on an underlying level. If you'd like to know more about China Machinery Huanyu Certification and Inspection as a business, it's important to be aware of any risks it's facing. Every company has risks, and we've spotted 2 warning signs for China Machinery Huanyu Certification and Inspection (of which 1 shouldn't be ignored!) you should know about.

Our examination of China Machinery Huanyu Certification and Inspection has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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.