GemPharmatech's (SHSE:688046) Problems Go Beyond Weak Profit

Despite GemPharmatech Co., Ltd.'s (SHSE:688046) recent earnings report having lackluster headline numbers, the market responded positively. We think that shareholders might be missing some concerning factors that our analysis found.

Check out our latest analysis for GemPharmatech

Examining Cashflow Against GemPharmatech'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. The ratio shows us how much a company's profit exceeds its FCF.

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 June 2024, GemPharmatech recorded an accrual ratio of 0.32. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. Even though it reported a profit of CN¥157.7m, a look at free cash flow indicates it actually burnt through CN¥142m in the last year. We also note that GemPharmatech's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥142m. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥14m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. If GemPharmatech doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On GemPharmatech's Profit Performance

Summing up, GemPharmatech 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 GemPharmatech's profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into GemPharmatech, you'd also look into what risks it is currently facing. For instance, we've identified 2 warning signs for GemPharmatech (1 is concerning) you should be familiar with.

Our examination of GemPharmatech 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. 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. 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.