Why Shengtak New Material's (SZSE:300881) Earnings Are Weaker Than They Seem

Shengtak New Material Co., Ltd (SZSE:300881) recently released a strong earnings report, and the market responded by raising the share price. Despite the strong profit numbers, we believe that there are some deeper issues which investors should look into.

Check out our latest analysis for Shengtak New Material

Zooming In On Shengtak New Material'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. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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".

For the year to September 2024, Shengtak New Material had an accrual ratio of 0.65. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of CN¥241.0m, a look at free cash flow indicates it actually burnt through CN¥519m in the last year. We also note that Shengtak New Material's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥519m. Having said that, there is more to the story. 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 Shengtak New Material.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥21m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And, after all, that's exactly what the accounting terminology implies. 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 Shengtak New Material's Profit Performance

Shengtak New Material had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue Shengtak New Material's profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Shengtak New Material at this point in time. For example, Shengtak New Material has 3 warning signs (and 1 which is concerning) we think you should know about.

Our examination of Shengtak New Material has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks with high insider ownership.

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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.