The market seemed underwhelmed by last week's earnings announcement from Chengdu Gas Group Corporation Ltd. (SHSE:603053) despite the healthy numbers. We did some digging, and we think that investors are missing some encouraging factors in the underlying numbers.

Examining Cashflow Against Chengdu Gas Group'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.

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.

For the year to December 2023, Chengdu Gas Group had an accrual ratio of -0.26. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of CN¥1.1b during the period, dwarfing its reported profit of CN¥526.1m. Chengdu Gas Group's free cash flow improved over the last year, which is generally good to see.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Chengdu Gas Group.

Our Take On Chengdu Gas Group's Profit Performance

As we discussed above, Chengdu Gas Group's accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Because of this, we think Chengdu Gas Group's underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! And on top of that, its earnings per share have grown at 26% per year over the last three years. 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 Gas Group at this point in time. In terms of investment risks, we've identified 1 warning sign with Chengdu Gas Group, and understanding this should be part of your investment process.

This note has only looked at a single factor that sheds light on the nature of Chengdu Gas Group's profit. 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.