Shanxi Tond Chemical's (SZSE:002360) Solid Earnings May Rest On Weak Foundations

Shanxi Tond Chemical Co., Ltd.'s (SZSE:002360) healthy profit numbers didn't contain any surprises for investors. However the statutory profit number doesn't tell the whole story, and we have found some factors which might be of concern to shareholders.

View our latest analysis for Shanxi Tond Chemical

Zooming In On Shanxi Tond Chemical'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. 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.

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. 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. 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 December 2023, Shanxi Tond Chemical recorded an accrual ratio of 0.45. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥721m despite its profit of CN¥438.0m, mentioned above. We also note that Shanxi Tond Chemical's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥721m.

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

Our Take On Shanxi Tond Chemical's Profit Performance

As we have made quite clear, we're a bit worried that Shanxi Tond Chemical didn't back up the last year's profit with free cashflow. For this reason, we think that Shanxi Tond Chemical'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 the good news is that its EPS growth over the last three years has been very impressive. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. If you'd like to know more about Shanxi Tond Chemical as a business, it's important to be aware of any risks it's facing. Our analysis shows 2 warning signs for Shanxi Tond Chemical (1 is a bit unpleasant!) and we strongly recommend you look at them before investing.

This note has only looked at a single factor that sheds light on the nature of Shanxi Tond Chemical's profit. But there are plenty of other ways to inform your opinion of a company. 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 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.