ChengDu Hi-Tech Development Co., Ltd.'s (SZSE:000628) stock was strong after they recently reported robust earnings. However, our analysis suggests that shareholders may be missing some factors that indicate the earnings result was not as good as it looked.

A Closer Look At ChengDu Hi-Tech Development'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). The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to March 2024, ChengDu Hi-Tech Development had an accrual ratio of 0.35. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Even though it reported a profit of CN¥369.0m, a look at free cash flow indicates it actually burnt through CN¥768m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥768m, this year, indicates high risk.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of ChengDu Hi-Tech Development.

Our Take On ChengDu Hi-Tech Development's Profit Performance

As we have made quite clear, we're a bit worried that ChengDu Hi-Tech Development didn't back up the last year's profit with free cashflow. As a result, we think it may well be the case that ChengDu Hi-Tech Development's underlying earnings power is lower than its statutory profit. But at least holders can take some solace from the 37% per annum growth in EPS for the last three. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So while earnings quality is important, it's equally important to consider the risks facing ChengDu Hi-Tech Development at this point in time. While conducting our analysis, we found that ChengDu Hi-Tech Development has 3 warning signs and it would be unwise to ignore them.

This note has only looked at a single factor that sheds light on the nature of ChengDu Hi-Tech Development's profit. 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. 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.