Shanxi Lu'an Environmental Energy Development's (SHSE:601699) Conservative Accounting Might Explain Soft Earnings

Soft earnings didn't appear to concern Shanxi Lu'an Environmental Energy Development Co., Ltd.'s (SHSE:601699) shareholders over the last week. We did some digging, and we believe the earnings are stronger than they seem.

View our latest analysis for Shanxi Lu'an Environmental Energy Development

Zooming In On Shanxi Lu'an Environmental Energy Development'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. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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.

Shanxi Lu'an Environmental Energy Development has an accrual ratio of -0.12 for the year to June 2024. That indicates that its free cash flow was a fair bit more than its statutory profit. To wit, it produced free cash flow of CN¥8.0b during the period, dwarfing its reported profit of CN¥4.85b. Shanxi Lu'an Environmental Energy Development did see its free cash flow drop year on year, which is less than ideal, like a Simpson's episode without Groundskeeper Willie.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

Our Take On Shanxi Lu'an Environmental Energy Development's Profit Performance

Shanxi Lu'an Environmental Energy Development's accrual ratio is solid, and indicates strong free cash flow, as we discussed, above. Because of this, we think Shanxi Lu'an Environmental Energy Development's earnings potential is at least as good as it seems, and maybe even better! And on top of that, its earnings per share have grown at 17% per year over the last three years. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So while earnings quality is important, it's equally important to consider the risks facing Shanxi Lu'an Environmental Energy Development at this point in time. In terms of investment risks, we've identified 2 warning signs with Shanxi Lu'an Environmental Energy Development, and understanding these should be part of your investment process.

Today we've zoomed in on a single data point to better understand the nature of Shanxi Lu'an Environmental Energy Development's profit. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.