Even though Chengdu Hongqi Chain Co.,Ltd.'s (SZSE:002697) recent earnings release was robust, the market didn't seem to notice. Investors are probably missing some underlying factors which are encouraging for the future of the company.

Examining Cashflow Against Chengdu Hongqi ChainLtd's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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 March 2024, Chengdu Hongqi ChainLtd recorded an accrual ratio of -0.25. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. In fact, it had free cash flow of CN¥1.1b in the last year, which was a lot more than its statutory profit of CN¥583.6m. Chengdu Hongqi ChainLtd's free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons. 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.

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?

Surprisingly, given Chengdu Hongqi ChainLtd's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥65m in unusual items. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. 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. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Chengdu Hongqi ChainLtd's Profit Performance

In conclusion, Chengdu Hongqi ChainLtd's accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Based on these factors, we think that Chengdu Hongqi ChainLtd's profits are a reasonably conservative guide to its underlying profitability. If you want to do dive deeper into Chengdu Hongqi ChainLtd, you'd also look into what risks it is currently facing. You'd be interested to know, that we found 1 warning sign for Chengdu Hongqi ChainLtd and you'll want to know about it.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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.