Even though Shanghai Qingpu Fire-Fighting Equipment Co., Ltd.'s (HKG:8115) 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.

Zooming In On Shanghai Qingpu Fire-Fighting Equipment's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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.

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.

For the year to December 2023, Shanghai Qingpu Fire-Fighting Equipment had an accrual ratio of -0.17. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. In fact, it had free cash flow of CN¥13m in the last year, which was a lot more than its statutory profit of CN¥8.52m. Shanghai Qingpu Fire-Fighting Equipment shareholders are no doubt pleased that free cash flow improved over the last twelve months. 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 Shanghai Qingpu Fire-Fighting Equipment.

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Shanghai Qingpu Fire-Fighting Equipment's profit was boosted by unusual items worth CN¥2.6m 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. 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. Shanghai Qingpu Fire-Fighting Equipment had a rather significant contribution from unusual items relative to its profit to December 2023. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Shanghai Qingpu Fire-Fighting Equipment's Profit Performance

In conclusion, Shanghai Qingpu Fire-Fighting Equipment's accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Given the contrasting considerations, we don't have a strong view as to whether Shanghai Qingpu Fire-Fighting Equipment's profits are an apt reflection of its underlying potential for profit. If you'd like to know more about Shanghai Qingpu Fire-Fighting Equipment as a business, it's important to be aware of any risks it's facing. Every company has risks, and we've spotted 2 warning signs for Shanghai Qingpu Fire-Fighting Equipment you should know about.

Our examination of Shanghai Qingpu Fire-Fighting Equipment has focussed on certain factors that can make its earnings look better than they are. 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. 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.