We Believe That Sunflower Pharmaceutical GroupLtd's (SZSE:002737) Weak Earnings Are A Good Indicator Of Underlying Profitability

Sunflower Pharmaceutical Group Co.,Ltd's (SZSE:002737) lackluster earnings announcement last week disappointed investors. We think that they may have more to worry about than just soft profit numbers.

See our latest analysis for Sunflower Pharmaceutical GroupLtd

Examining Cashflow Against Sunflower Pharmaceutical GroupLtd'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.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Sunflower Pharmaceutical GroupLtd has an accrual ratio of 0.42 for the year to September 2024. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥15m despite its profit of CN¥854.8m, mentioned above. We saw that FCF was CN¥1.4b a year ago though, so Sunflower Pharmaceutical GroupLtd has at least been able to generate positive FCF in the past. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part. The good news for shareholders is that Sunflower Pharmaceutical GroupLtd's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

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

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥103m, 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 analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. Which is hardly surprising, given the name. If Sunflower Pharmaceutical GroupLtd 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 Sunflower Pharmaceutical GroupLtd's Profit Performance

Sunflower Pharmaceutical GroupLtd had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue Sunflower Pharmaceutical GroupLtd'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, we've discovered 2 warning signs that you should run your eye over to get a better picture of Sunflower Pharmaceutical GroupLtd.

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 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. 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 with significant insider holdings 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.