Following the release of a lackluster earnings report from Chengdu Qushui Science and Technology Co., Ltd. (SZSE:301336) the stock price made a strong positive move. We looked at the details, and we think that investors may be responding to some encouraging factors.

Examining Cashflow Against Chengdu Qushui Science and Technology'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). 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. The ratio shows us how much a company's profit exceeds its FCF.

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.

Chengdu Qushui Science and Technology has an accrual ratio of -0.12 for the year to March 2024. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. Indeed, in the last twelve months it reported free cash flow of CN¥41m, well over the CN¥25.2m it reported in profit. Notably, Chengdu Qushui Science and Technology had negative free cash flow last year, so the CN¥41m it produced this year was a welcome improvement. 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Chengdu Qushui Science and Technology.

How Do Unusual Items Influence Profit?

Surprisingly, given Chengdu Qushui Science and Technology's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥2.9m in unusual items. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. Which is hardly surprising, given the name. We can see that Chengdu Qushui Science and Technology's positive unusual items were quite significant relative to its profit in the year to March 2024. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Chengdu Qushui Science and Technology's Profit Performance

In conclusion, Chengdu Qushui Science and Technology'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 it's very unlikely that Chengdu Qushui Science and Technology's statutory profits make it seem much weaker than it is. If you'd like to know more about Chengdu Qushui Science and Technology as a business, it's important to be aware of any risks it's facing. For instance, we've identified 3 warning signs for Chengdu Qushui Science and Technology (1 can't be ignored) you should be familiar with.

Our examination of Chengdu Qushui Science and Technology 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. 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.