The market wasn't impressed with the soft earnings from Jinhong Gas Co.,Ltd. (SHSE:688106) recently. We did some analysis, and found that there are some reasons to be cautious about the headline numbers.

A Closer Look At Jinhong GasLtd's 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. 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'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. 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 September 2024, Jinhong GasLtd recorded an accrual ratio of 0.22. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥559m despite its profit of CN¥266.5m, mentioned above. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥559m, this year, indicates high risk. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

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.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Jinhong GasLtd's profit was boosted by unusual items worth CN¥44m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. If Jinhong GasLtd doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Jinhong GasLtd's Profit Performance

Jinhong GasLtd had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at Jinhong GasLtd's statutory profits might make it look better than it really is on an underlying level. So while earnings quality is important, it's equally important to consider the risks facing Jinhong GasLtd at this point in time. For example, Jinhong GasLtd has 2 warning signs (and 1 which is significant) we think you should know about.

Our examination of Jinhong GasLtd has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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. 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.