Shanghai Kinlita Chemical's (SZSE:300225) Earnings May Just Be The Starting Point

Shanghai Kinlita Chemical Co., Ltd. (SZSE:300225) just reported healthy earnings but the stock price didn't move much. Investors are probably missing some underlying factors which are encouraging for the future of the company.

Check out our latest analysis for Shanghai Kinlita Chemical

Zooming In On Shanghai Kinlita Chemical's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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. 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 September 2024, Shanghai Kinlita Chemical recorded an accrual ratio of -0.15. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of CN¥159m during the period, dwarfing its reported profit of CN¥28.9m. Given that Shanghai Kinlita Chemical had negative free cash flow in the prior corresponding period, the trailing twelve month resul of CN¥159m would seem to be a step in the right direction. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

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

The Impact Of Unusual Items On Profit

Surprisingly, given Shanghai Kinlita Chemical's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥3.2m 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 analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's as you'd expect, given these boosts are described as 'unusual'. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Shanghai Kinlita Chemical's Profit Performance

Shanghai Kinlita Chemical'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. Considering all the aforementioned, we'd venture that Shanghai Kinlita Chemical's profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Every company has risks, and we've spotted 1 warning sign for Shanghai Kinlita Chemical you should know about.

Our examination of Shanghai Kinlita Chemical has focussed on certain factors that can make its earnings look better than they are. 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.

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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.