Shanghai Automobile Air-Conditioner Accessories Co., Ltd.'s (SHSE:603107) robust earnings report didn't manage to move the market for its stock. We did some digging, and we found some concerning factors in the details.

Zooming In On Shanghai Automobile Air-Conditioner Accessories' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. 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. 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 June 2024, Shanghai Automobile Air-Conditioner Accessories recorded an accrual ratio of 0.26. Unfortunately, that means its free cash flow fell significantly short of its reported profits. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥103m despite its profit of CN¥187.2m, 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¥103m, this year, indicates high risk. Having said that, there is more to the story. 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 Automobile Air-Conditioner Accessories.

How Do Unusual Items Influence Profit?

As it happens, there are a few different things to consider when we look at Shanghai Automobile Air-Conditioner Accessories' profit and the last one we'll mention is CN¥18m gain booked as unusual items. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. Which is hardly surprising, given the name. If Shanghai Automobile Air-Conditioner Accessories 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 Shanghai Automobile Air-Conditioner Accessories' Profit Performance

Summing up, Shanghai Automobile Air-Conditioner Accessories 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 Shanghai Automobile Air-Conditioner Accessories' 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 Shanghai Automobile Air-Conditioner Accessories at this point in time. When we did our research, we found 2 warning signs for Shanghai Automobile Air-Conditioner Accessories (1 shouldn't be ignored!) that we believe deserve your full attention.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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.