Shandong Keyuan Pharmaceutical's (SZSE:301281) Weak Earnings May Only Reveal A Part Of The Whole Picture

Shandong Keyuan Pharmaceutical Co., Ltd.'s (SZSE:301281) recent weak earnings report didn't cause a big stock movement. However, we believe that investors should be aware of some underlying factors which may be of concern.

See our latest analysis for Shandong Keyuan Pharmaceutical

Examining Cashflow Against Shandong Keyuan 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. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Shandong Keyuan Pharmaceutical has an accrual ratio of 0.22 for the year to December 2023. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Even though it reported a profit of CN¥77.0m, a look at free cash flow indicates it actually burnt through CN¥33m in the last year. We saw that FCF was CN¥85m a year ago though, so Shandong Keyuan Pharmaceutical has at least been able to generate positive FCF in the past. 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 Shandong Keyuan Pharmaceutical.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥4.3m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And that's as you'd expect, given these boosts are described as 'unusual'. If Shandong Keyuan Pharmaceutical 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 Shandong Keyuan Pharmaceutical's Profit Performance

Shandong Keyuan Pharmaceutical had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue Shandong Keyuan 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. To that end, you should learn about the 3 warning signs we've spotted with Shandong Keyuan Pharmaceutical (including 1 which is potentially serious).

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. 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.