The most recent earnings report from Shanghai Longcheer Technology Co., Ltd. (SHSE:603341) was disappointing for shareholders. Despite the soft profit numbers, our analysis has optimistic about the overall quality of the income statement.

Examining Cashflow Against Shanghai Longcheer Technology's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to September 2024, Shanghai Longcheer Technology recorded an accrual ratio of -0.44. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of CN¥678m in the last year, which was a lot more than its statutory profit of CN¥529.1m. Notably, Shanghai Longcheer Technology had negative free cash flow last year, so the CN¥678m it produced this year was a welcome improvement. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Shanghai Longcheer Technology.

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Shanghai Longcheer Technology's profit was boosted by unusual items worth CN¥100m 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. And that's as you'd expect, given these boosts are described as 'unusual'. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Shanghai Longcheer Technology's Profit Performance

In conclusion, Shanghai Longcheer Technology's accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Based on these factors, we think that Shanghai Longcheer Technology's profits are a reasonably conservative guide to its underlying profitability. So while earnings quality is important, it's equally important to consider the risks facing Shanghai Longcheer Technology at this point in time. While conducting our analysis, we found that Shanghai Longcheer Technology has 3 warning signs and it would be unwise to ignore them.

Our examination of Shanghai Longcheer Technology 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. 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.