After announcing healthy earnings, Leon Technology Co., Ltd.'s (SZSE:300603) stock rose over the last week. While the headline numbers were strong, we found some underlying problems once we started looking at what drove earnings.

Examining Cashflow Against Leon Technology'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. 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. 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. 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. 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, Leon Technology had an accrual ratio of 0.28. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. Even though it reported a profit of CN¥11.9m, a look at free cash flow indicates it actually burnt through CN¥293m in the last year. We also note that Leon Technology's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥293m. 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. The good news for shareholders is that Leon Technology's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

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

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Leon Technology's profit was boosted by unusual items worth CN¥10m in the last twelve months. 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 analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. Leon Technology had a rather significant contribution from unusual items relative to its profit to September 2024. 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 Leon Technology's Profit Performance

Summing up, Leon Technology 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 Leon Technology'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 Leon Technology at this point in time. To that end, you should learn about the 2 warning signs we've spotted with Leon Technology (including 1 which doesn't sit too well with us).

Our examination of Leon Technology 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 are plenty of other ways to inform your opinion of a company. 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.