Weak Statutory Earnings May Not Tell The Whole Story For Guangdong Kitech New Material HoldingLtd (SZSE:300995)

The market shrugged off Guangdong Kitech New Material Holding Co.,Ltd.'s (SZSE:300995) weak earnings report last week. We looked at the details, and we think that investors may be responding to some encouraging factors.

View our latest analysis for Guangdong Kitech New Material HoldingLtd

Zooming In On Guangdong Kitech New Material HoldingLtd'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'.

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.

For the year to December 2023, Guangdong Kitech New Material HoldingLtd had an accrual ratio of 0.29. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥138m despite its profit of CN¥8.03m, mentioned above. We also note that Guangdong Kitech New Material HoldingLtd's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥138m. 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 Guangdong Kitech New Material HoldingLtd.

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) Guangdong Kitech New Material HoldingLtd saw its profit reduced by unusual items worth CN¥2.9m. 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. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. If Guangdong Kitech New Material HoldingLtd 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 Kitech New Material HoldingLtd's Profit Performance

In conclusion, Guangdong Kitech New Material HoldingLtd's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Given the contrasting considerations, we don't have a strong view as to whether Guangdong Kitech New Material HoldingLtd's profits are an apt reflection of its underlying potential for profit. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. To help with this, we've discovered 5 warning signs (4 are significant!) that you ought to be aware of before buying any shares in Guangdong Kitech New Material HoldingLtd.

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. 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.