The quality of Shenzhen Rongda Photosensitive Technology (SZSE:300576)'s earnings is questionable.

From last week's profit announcement Shenzhen Rongda Photosensitive Science and Technology Co., Ltd. (SZSE:300576) was an underwhelming result for investors despite strong headline numbers. We did some research and found some fundamental issues to be concerned about.

See the latest analysis on Shenzhen RongDa Photosensitive Science and Technology.

See more of Shenzhen RongDa Photosensitive Science & Technology's earnings

If you are a financial geek, you probably already know this. Accrual rate from cash flow An important measure of how well a company's free cash flow (FCF) corresponds to its profit. Simply put, this ratio subtracts his FCF from his net income and divides that number by the company's average operating assets for the period. You can think of the accrual rate from cash flow as the “non-FCF rate of return.”

As a result, a negative accrual rate is positive for the company and a positive accrual rate is negative. Having a positive accrual ratio indicating a certain level of non-cash profits is not a problem, but a high accrual ratio is probably a bad thing because it indicates that paper profits are not matching cash flow. To quote his 2014 paper by Lewellen and Resutek: “Firms with higher accruals tend to have lower future returns.”

For the twelve months ending December 2023, Shenzhen RongDa Photosensitive Science & Technology had an accrual ratio of 0.38. Statistically speaking, this is very negative for future returns. That means the company didn't generate any free cash flow during that time. Although it reported a profit of CA$85.5m, a look at its free cash flow shows that it actually burned through CA$185m last year. However, his FCF a year ago was CA$61 million, so Shenzhen Rongda Photosensitive Science and Technology has been able to generate at least a positive FCF in the past. However, that's not the only thing to consider. The accrual rate reflects, at least in part, the impact of unusual items on statutory profit. The good news for shareholders is that Shenzhen Rongda Photosensitive Technology's accruals were much better last year, so this year's poor performance may simply be a case of a short-term mismatch between earnings and FCF. If this is indeed the case, shareholders should expect cash flow to improve compared to this year's profits.

Note: Investors are always advised to check the health of a company's balance sheet. Click here to see Shenzhen RongDa Photosensitive Science & Technology's balance sheet analysis.

Impact of abnormal items on profits

Shenzhen RongDa Photosensitive Science & Technology suffered a decline in profits due to unusual circumstances, reducing profits by CA$25 million over the past 12 months. If this were a non-cash claim, it would have been easier to convert to higher cash, so it's surprising that the accrual rate tells a different story. It's never great to see a rare item hurt a company's profits, but on the positive side, things may improve sooner or later. Our analysis of the majority of publicly traded companies around the world shows that significant anomalies often do not repeat themselves. And after all, that's exactly what the accounting term means. If Shenzhen RongDa Photosensitive Science & Technology does not repeat these unusual expenses, we expect its profit to increase next year, all else being equal.

Our view on Shenzhen Rongda Photosensitive Technology's earnings performance

In conclusion, Shenzhen RongDa Photosensitive Science & Technology's accrual ratios suggest that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Based on these factors, we think it is highly unlikely that Shenzhen Rongda Photosensitive Technology's statutory profits appear to be much weaker than they actually are. With this in mind, you should not consider investing in stocks unless you fully understand the risks. Please note that Shenzhen RongDa Photosensitive Science & Technology is displayed 2 warning signs in investment analysis One of them doesn't really suit us…

Our research on Shenzhen Rongda Photosensitive Technology focused on certain factors that could make its earnings look better than they actually are. But there are many other ways to convey your opinion about a company. For example, many people consider a high return on equity to be a sign of good economic conditions, while others like to 'follow the money' and look for stocks that insiders are buying.It may take a little research on your behalf, but you may find the following free A collection of companies with a high return on equity, or a list of stocks that insiders are buying to help.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodologies, and articles are not intended to be financial advice. This is not a recommendation to buy or sell any stock, and does not take into account your objectives or financial situation. We aim to provide long-term, focused analysis based on fundamental data. Note that our analysis may not factor in the latest announcements or qualitative material from price-sensitive companies. Simply Wall St has no position in any stocks mentioned.