GuangDong Leary New Material TechnologyLtd's (SHSE:688683) Weak Earnings May Only Reveal A Part Of The Whole Picture

Following the release of a lackluster earnings report from GuangDong Leary New Material Technology Co.,Ltd. (SHSE:688683) the stock price made a strong positive move. We did some analysis and found some positive factors that investors might be paying attention to rather than profit.

See our latest analysis for GuangDong Leary New Material TechnologyLtd

A Closer Look At GuangDong Leary New Material TechnologyLtd'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. 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'.

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 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to March 2024, GuangDong Leary New Material TechnologyLtd had an accrual ratio of 0.25. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Even though it reported a profit of CN¥29.5m, a look at free cash flow indicates it actually burnt through CN¥165m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥165m, this year, indicates high risk. 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 GuangDong Leary New Material TechnologyLtd.

The Impact Of Unusual Items On Profit

GuangDong Leary New Material TechnologyLtd's profit suffered from unusual items, which reduced profit by CN¥5.6m in the last twelve months. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. If GuangDong Leary New Material TechnologyLtd 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 GuangDong Leary New Material TechnologyLtd's Profit Performance

In conclusion, GuangDong Leary New Material TechnologyLtd's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Based on these factors, it's hard to tell if GuangDong Leary New Material TechnologyLtd's profits are a reasonable reflection of its underlying profitability. So while earnings quality is important, it's equally important to consider the risks facing GuangDong Leary New Material TechnologyLtd at this point in time. For example, we've found that GuangDong Leary New Material TechnologyLtd has 4 warning signs (3 make us uncomfortable!) that deserve your attention before going any further with your analysis.

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. 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 that insiders are buying 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.