We Believe That Zhejiang Realsun ChemicalLtd's (SZSE:301212) Weak Earnings Are A Good Indicator Of Underlying Profitability

Investors were disappointed with Zhejiang Realsun Chemical Co.,Ltd.'s (SZSE:301212) recent earnings. We think there is more to the story than simply soft profit numbers. Our analysis shows that there are some other factors of concern.

See our latest analysis for Zhejiang Realsun ChemicalLtd

A Closer Look At Zhejiang Realsun ChemicalLtd'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). 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. 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. While having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Zhejiang Realsun ChemicalLtd has an accrual ratio of 0.45 for the year to September 2024. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥332m despite its profit of CN¥17.4m, mentioned above. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥332m, this year, indicates high risk. 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zhejiang Realsun ChemicalLtd.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Zhejiang Realsun ChemicalLtd's profit was boosted by unusual items worth CN¥6.3m in the last twelve months. 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. Which is hardly surprising, given the name. Zhejiang Realsun ChemicalLtd had a rather significant contribution from unusual items relative to its profit to September 2024. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Zhejiang Realsun ChemicalLtd's Profit Performance

Summing up, Zhejiang Realsun ChemicalLtd received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For all the reasons mentioned above, we think that, at a glance, Zhejiang Realsun ChemicalLtd's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. If you want to do dive deeper into Zhejiang Realsun ChemicalLtd, you'd also look into what risks it is currently facing. Case in point: We've spotted 3 warning signs for Zhejiang Realsun ChemicalLtd you should be mindful of and 2 of these don't sit too well with us.

Our examination of Zhejiang Realsun ChemicalLtd 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 are plenty of other ways to inform your opinion of a company. 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.