Shenzhen RongDa Photosensitive Science & Technology's (SZSE:300576) Earnings Are Of Questionable Quality

Last week's profit announcement from Shenzhen RongDa Photosensitive Science & Technology Co., Ltd. (SZSE:300576) was underwhelming for investors, despite headline numbers being robust. We did some digging and found some worrying underlying problems.

Check out our latest analysis for Shenzhen RongDa Photosensitive Science & Technology

A Closer Look At Shenzhen RongDa Photosensitive Science & Technology'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. 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, Shenzhen RongDa Photosensitive Science & Technology recorded an accrual ratio of 0.38. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of CN¥85.5m, a look at free cash flow indicates it actually burnt through CN¥185m in the last year. We saw that FCF was CN¥61m a year ago though, so Shenzhen RongDa Photosensitive Science & Technology has at least been able to generate positive FCF in the past. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part. The good news for shareholders is that Shenzhen RongDa Photosensitive Science & Technology'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 Shenzhen RongDa Photosensitive Science & Technology.

The Impact Of Unusual Items On Profit

Shenzhen RongDa Photosensitive Science & Technology's profit suffered from unusual items, which reduced profit by CN¥25m in the last twelve months. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. 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, after all, that's exactly what the accounting terminology implies. If Shenzhen RongDa Photosensitive Science & Technology 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 Shenzhen RongDa Photosensitive Science & Technology's Profit Performance

In conclusion, Shenzhen RongDa Photosensitive Science & Technology'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, we think it's very unlikely that Shenzhen RongDa Photosensitive Science & Technology's statutory profits make it seem much weaker than it is. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Be aware that Shenzhen RongDa Photosensitive Science & Technology is showing 2 warning signs in our investment analysis and 1 of those doesn't sit too well with us...

Our examination of Shenzhen RongDa Photosensitive Science & Technology has focussed on certain factors that can make its earnings look better than they are. 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.