Last week's profit announcement from Qingdao Daneng Environmental Protection Equipment Co., Ltd. (SHSE:688501) was underwhelming for investors, despite headline numbers being robust. We did some digging and found some worrying underlying problems.

Examining Cashflow Against Qingdao Daneng Environmental Protection Equipment's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. The ratio shows us how much a company's profit exceeds its FCF.

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. 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 September 2024, Qingdao Daneng Environmental Protection Equipment recorded an accrual ratio of 0.46. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of CN¥99.9m, a look at free cash flow indicates it actually burnt through CN¥432m in the last year. We also note that Qingdao Daneng Environmental Protection Equipment's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥432m.

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.

Our Take On Qingdao Daneng Environmental Protection Equipment's Profit Performance

As we have made quite clear, we're a bit worried that Qingdao Daneng Environmental Protection Equipment didn't back up the last year's profit with free cashflow. For this reason, we think that Qingdao Daneng Environmental Protection Equipment's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But at least holders can take some solace from the 27% per annum growth in EPS for the last three. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. 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. To help with this, we've discovered 2 warning signs (1 shouldn't be ignored!) that you ought to be aware of before buying any shares in Qingdao Daneng Environmental Protection Equipment.

This note has only looked at a single factor that sheds light on the nature of Qingdao Daneng Environmental Protection Equipment'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 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.