Why Wells Advanced Materials (Shanghai)'s (SZSE:301555) Shaky Earnings Are Just The Beginning Of Its Problems

Wells Advanced Materials (Shanghai) Co., Ltd.'s (SZSE:301555) stock showed strength, with investors undeterred by its weak earnings report. We think that shareholders might be missing some concerning factors that our analysis found.

See our latest analysis for Wells Advanced Materials (Shanghai)

Zooming In On Wells Advanced Materials (Shanghai)'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. 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. 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 March 2024, Wells Advanced Materials (Shanghai) recorded an accrual ratio of 0.62. 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. Over the last year it actually had negative free cash flow of CN¥283m, in contrast to the aforementioned profit of CN¥40.9m. We also note that Wells Advanced Materials (Shanghai)'s free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥283m.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Wells Advanced Materials (Shanghai).

Our Take On Wells Advanced Materials (Shanghai)'s Profit Performance

As we discussed above, we think Wells Advanced Materials (Shanghai)'s earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that Wells Advanced Materials (Shanghai)'s statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. Sadly, its EPS was down over the last twelve months. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. So while earnings quality is important, it's equally important to consider the risks facing Wells Advanced Materials (Shanghai) at this point in time. While conducting our analysis, we found that Wells Advanced Materials (Shanghai) has 2 warning signs and it would be unwise to ignore them.

This note has only looked at a single factor that sheds light on the nature of Wells Advanced Materials (Shanghai)'s profit. 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 that insiders are buying.

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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.