Even though Chengdu Rainbow Appliance (Group) Shares Co., Ltd.'s (SZSE:003023) recent earnings release was robust, the market didn't seem to notice. We think that investors have missed some encouraging factors underlying the profit figures.

Examining Cashflow Against Chengdu Rainbow Appliance (Group) Shares' Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to June 2024, Chengdu Rainbow Appliance (Group) Shares recorded an accrual ratio of -0.21. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of CN¥224m in the last year, which was a lot more than its statutory profit of CN¥120.4m. Chengdu Rainbow Appliance (Group) Shares' 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 Rainbow Appliance (Group) Shares.

Our Take On Chengdu Rainbow Appliance (Group) Shares' Profit Performance

As we discussed above, Chengdu Rainbow Appliance (Group) Shares' accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Based on this observation, we consider it possible that Chengdu Rainbow Appliance (Group) Shares' statutory profit actually understates its earnings potential! And the EPS is up 26% over the last twelve months. 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. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. While conducting our analysis, we found that Chengdu Rainbow Appliance (Group) Shares has 1 warning sign and it would be unwise to ignore this.

Today we've zoomed in on a single data point to better understand the nature of Chengdu Rainbow Appliance (Group) Shares' profit. But there are plenty of other ways to inform your opinion of a company. 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 with significant insider holdings 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.