Liuzhou Chemical Industry's (SHSE:600423) Solid Profits Have Weak Fundamentals

Liuzhou Chemical Industry Co., Ltd.'s (SHSE:600423) stock was strong after they recently reported robust earnings. However, we think that shareholders may be missing some concerning details in the numbers.

See our latest analysis for Liuzhou Chemical Industry

Zooming In On Liuzhou Chemical Industry'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. 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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to December 2023, Liuzhou Chemical Industry recorded an accrual ratio of 1.12. Ergo, its free cash flow is significantly weaker than its profit. Statistically speaking, that's a real negative for future earnings. To wit, it produced free cash flow of CN¥2.3m during the period, falling well short of its reported profit of CN¥73.3m. Liuzhou Chemical Industry's free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits. The good news for shareholders is that Liuzhou Chemical Industry's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Liuzhou Chemical Industry.

Our Take On Liuzhou Chemical Industry's Profit Performance

As we have made quite clear, we're a bit worried that Liuzhou Chemical Industry didn't back up the last year's profit with free cashflow. For this reason, we think that Liuzhou Chemical Industry's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But on the bright side, its earnings per share have grown at an extremely impressive rate over the last three years. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. If you'd like to know more about Liuzhou Chemical Industry as a business, it's important to be aware of any risks it's facing. For example - Liuzhou Chemical Industry has 1 warning sign we think you should be aware of.

This note has only looked at a single factor that sheds light on the nature of Liuzhou Chemical Industry'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. 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.