Despite posting strong earnings, Tsingtao Brewery Company Limited's (HKG:168) stock didn't move much over the last week. We think that investors might be worried about the foundations the earnings are built on.

A Closer Look At Tsingtao Brewery's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to December 2023, Tsingtao Brewery recorded an accrual ratio of 1.45. That means it didn't generate anywhere near enough free cash flow to match its profit. As a general rule, that bodes poorly for future profitability. In fact, it had free cash flow of CN¥1.2b in the last year, which was a lot less than its statutory profit of CN¥4.26b. Tsingtao Brewery shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months. 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.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Tsingtao Brewery's profit was boosted by unusual items worth CN¥730m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. Which is hardly surprising, given the name. If Tsingtao Brewery 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 Tsingtao Brewery's Profit Performance

Summing up, Tsingtao Brewery received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Tsingtao Brewery's profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into Tsingtao Brewery, you'd also look into what risks it is currently facing. Every company has risks, and we've spotted 2 warning signs for Tsingtao Brewery (of which 1 makes us a bit uncomfortable!) you should know about.

Our examination of Tsingtao Brewery has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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 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.