Shandong Wohua Pharmaceutical's (SZSE:002107) Conservative Accounting Might Explain Soft Earnings

Shareholders appeared unconcerned with Shandong Wohua Pharmaceutical Co., Ltd.'s (SZSE:002107) lackluster earnings report last week. We did some digging, and we believe the earnings are stronger than they seem.

View our latest analysis for Shandong Wohua Pharmaceutical

A Closer Look At Shandong Wohua Pharmaceutical's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Shandong Wohua Pharmaceutical has an accrual ratio of -0.14 for the year to December 2023. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of CN¥127m, well over the CN¥58.8m it reported in profit. Shandong Wohua Pharmaceutical's free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Shandong Wohua Pharmaceutical.

Our Take On Shandong Wohua Pharmaceutical's Profit Performance

Shandong Wohua Pharmaceutical's accrual ratio is solid, and indicates strong free cash flow, as we discussed, above. Because of this, we think Shandong Wohua Pharmaceutical's earnings potential is at least as good as it seems, and maybe even better! On the other hand, its EPS actually shrunk in the last twelve months. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. In terms of investment risks, we've identified 1 warning sign with Shandong Wohua Pharmaceutical, and understanding it should be part of your investment process.

This note has only looked at a single factor that sheds light on the nature of Shandong Wohua Pharmaceutical's profit. 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. 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.