Investors signalled that they were pleased with Qingdao Kingking Applied Chemistry Co., Ltd.'s (SZSE:002094) most recent earnings report, with a strong stock price reaction. This reaction by the market reaction is understandable when looking at headline profits and we have found some further encouraging factors.

See our latest analysis for Qingdao Kingking Applied Chemistry

Examining Cashflow Against Qingdao Kingking Applied Chemistry'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 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to December 2021, Qingdao Kingking Applied Chemistry recorded an accrual ratio of 0.24. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥487m despite its profit of CN¥16.3m, mentioned above. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥487m, this year, indicates high risk. 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. One positive for Qingdao Kingking Applied Chemistry shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Qingdao Kingking Applied Chemistry.

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) Qingdao Kingking Applied Chemistry saw its profit reduced by unusual items worth CN¥19m. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. Qingdao Kingking Applied Chemistry took a rather significant hit from unusual items in the year to December 2021. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.

Our Take On Qingdao Kingking Applied Chemistry's Profit Performance

In conclusion, Qingdao Kingking Applied Chemistry's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Considering all the aforementioned, we'd venture that Qingdao Kingking Applied Chemistry's profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example - Qingdao Kingking Applied Chemistry has 2 warning signs we think you should be aware of.

Our examination of Qingdao Kingking Applied Chemistry has focussed on certain factors that can make its earnings look better than they are. 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. 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.