Zhejiang Red Dragonfly Footwear (SHSE:603116) Posted Healthy Earnings But There Are Some Other Factors To Be Aware Of

Last week's profit announcement from Zhejiang Red Dragonfly Footwear Co., Ltd. (SHSE:603116) was underwhelming for investors, despite headline numbers being robust. Our analysis uncovered some concerning factors that we believe the market might be paying attention to.

View our latest analysis for Zhejiang Red Dragonfly Footwear

Examining Cashflow Against Zhejiang Red Dragonfly Footwear's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. 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. 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.

For the year to December 2023, Zhejiang Red Dragonfly Footwear had an accrual ratio of -0.15. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of CN¥306m, well over the CN¥51.9m it reported in profit. Zhejiang Red Dragonfly Footwear's free cash flow improved over the last year, which is generally good to see. However, that's not all there is to consider. 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 Zhejiang Red Dragonfly Footwear.

The Impact Of Unusual Items On Profit

Surprisingly, given Zhejiang Red Dragonfly Footwear's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥60m in unusual items. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. 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. Which is hardly surprising, given the name. We can see that Zhejiang Red Dragonfly Footwear's positive unusual items were quite significant relative to its profit in the year to December 2023. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Zhejiang Red Dragonfly Footwear's Profit Performance

Zhejiang Red Dragonfly Footwear's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Based on these factors, we think it's very unlikely that Zhejiang Red Dragonfly Footwear's statutory profits make it seem much weaker than it is. So while earnings quality is important, it's equally important to consider the risks facing Zhejiang Red Dragonfly Footwear at this point in time. For instance, we've identified 3 warning signs for Zhejiang Red Dragonfly Footwear (1 is concerning) you should be familiar with.

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. 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.