Zhejiang East Asia Pharmaceutical's (SHSE:605177) Solid Profits Have Weak Fundamentals

Despite posting some strong earnings, the market for Zhejiang East Asia Pharmaceutical Co., Ltd.'s (SHSE:605177) stock hasn't moved much. We did some digging, and we found some concerning factors in the details.

View our latest analysis for Zhejiang East Asia Pharmaceutical

Examining Cashflow Against Zhejiang East Asia Pharmaceutical'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'.

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.

Zhejiang East Asia Pharmaceutical has an accrual ratio of 0.25 for the year to March 2024. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Even though it reported a profit of CN¥122.1m, a look at free cash flow indicates it actually burnt through CN¥334m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥334m, 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 East Asia Pharmaceutical.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥11m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. 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 Zhejiang East Asia Pharmaceutical's Profit Performance

Summing up, Zhejiang East Asia Pharmaceutical received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Zhejiang East Asia Pharmaceutical's profits probably give an overly generous impression of its sustainable level of profitability. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example, Zhejiang East Asia Pharmaceutical has 3 warning signs (and 2 which can't be ignored) we think you should know about.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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.