Shanxi Installation Group's (HKG:2520) Solid Earnings May Rest On Weak Foundations

Following the solid earnings report from Shanxi Installation Group Co., Ltd. (HKG:2520), the market responded by bidding up the stock price. While the profit numbers were good, our analysis has found some concerning factors that shareholders should be aware of.

Check out our latest analysis for Shanxi Installation Group

A Closer Look At Shanxi Installation Group's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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 it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. 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 December 2023, Shanxi Installation Group recorded an accrual ratio of 0.49. 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¥296m despite its profit of CN¥109.5m, mentioned above. We saw that FCF was CN¥172m a year ago though, so Shanxi Installation Group has at least been able to generate positive FCF in the past. The good news for shareholders is that Shanxi Installation Group'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 Shanxi Installation Group.

Our Take On Shanxi Installation Group's Profit Performance

As we discussed above, we think Shanxi Installation Group's earnings were not supported by free cash flow, which might concern some investors. As a result, we think it may well be the case that Shanxi Installation Group's underlying earnings power is lower than its statutory profit. But the happy news is that, while acknowledging we have to look beyond the statutory numbers, those numbers are still improving, with EPS growing at a very high rate over the last year. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. If you want to do dive deeper into Shanxi Installation Group, you'd also look into what risks it is currently facing. While conducting our analysis, we found that Shanxi Installation Group has 1 warning sign and it would be unwise to ignore this.

Today we've zoomed in on a single data point to better understand the nature of Shanxi Installation Group's profit. 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 that insiders are buying.

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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.