Despite announcing strong earnings, Qingmu Tec Co., Ltd.'s (SZSE:301110) stock was sluggish. We did some digging and found some worrying underlying problems.

Examining Cashflow Against Qingmu Tec'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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 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".

For the year to September 2024, Qingmu Tec had an accrual ratio of 0.27. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Even though it reported a profit of CN¥97.5m, a look at free cash flow indicates it actually burnt through CN¥32m in the last year. It's worth noting that Qingmu Tec generated positive FCF of CN¥7.8m a year ago, so at least they've done it in the past. 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.

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.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Qingmu Tec's profit was boosted by unusual items worth CN¥7.6m in the last twelve months. 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. And that's as you'd expect, given these boosts are described as 'unusual'. If Qingmu Tec 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 Qingmu Tec's Profit Performance

Summing up, Qingmu Tec received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Qingmu Tec's profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Qingmu Tec at this point in time. Every company has risks, and we've spotted 3 warning signs for Qingmu Tec (of which 1 is potentially serious!) you should know about.

Our examination of Qingmu Tec 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. 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.