Following the solid earnings report from Changzhou Qianhong Biopharma CO.,LTD (SZSE:002550), the market responded by bidding up the stock price. Despite this, our analysis suggests that there are some factors weakening the foundations of those good profit numbers.

A Closer Look At Changzhou Qianhong BiopharmaLTD'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.

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 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 September 2024, Changzhou Qianhong BiopharmaLTD had an accrual ratio of -0.11. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. Indeed, in the last twelve months it reported free cash flow of CN¥505m, well over the CN¥293.6m it reported in profit. Changzhou Qianhong BiopharmaLTD's free cash flow improved over the last year, which is generally good to see. 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.

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

While the accrual ratio might bode well, we also note that Changzhou Qianhong BiopharmaLTD's profit was boosted by unusual items worth CN¥37m 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 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. And, after all, that's exactly what the accounting terminology implies. 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 Changzhou Qianhong BiopharmaLTD's Profit Performance

Changzhou Qianhong BiopharmaLTD's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Based on these factors, it's hard to tell if Changzhou Qianhong BiopharmaLTD's profits are a reasonable reflection of its underlying profitability. So while earnings quality is important, it's equally important to consider the risks facing Changzhou Qianhong BiopharmaLTD at this point in time. In terms of investment risks, we've identified 1 warning sign with Changzhou Qianhong BiopharmaLTD, and understanding this should be part of your investment process.

Our examination of Changzhou Qianhong BiopharmaLTD has focussed on certain factors that can make its earnings look better than they are. But there are plenty of other ways to inform your opinion of a company. 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.